Question

Explain briefly what the CPI measures and how it is constructed. Identify one reason why the CPI is an imperfect measure of the cost of living

Answer 1

The Consumer Price Index (CPI) measures the average change in prices paid by consumers for a representative basket of goods and services, such as transportation, food and medical care over a defined period of time. It is a statistical estimation that is constructed using the prices of a sample of representative items whose prices are periodically collected. It is computed by taking change in prices for each item in the predetermined basket of goods and then averaging them. It is often used as a measure of inflation, along with the GDP deflator.

The consumer price index is an imperfect measure of the cost of living because of the introduction of new goods, substitution bias, and unmeasured changes in quality. CPI does not consider the ability of consumers’ to substitute toward goods that become relatively cheaper over time. Consequently, the index overstates the increase in cost of living by not considering consumer substitution