Question

Calculating inflation using a simple price index 

Consider a fictional price index, the College Student Price Index (CSPI), based on a typical college student’s annual purchases. Suppose the following table shows information on the market basket for the CSPI and the prices of each of the goods in 2017, 2018, and 2019. The cost of each item in the basket and the total cost of the basket are shown for 2017. 

Perform these same calculations for 2018 and 2019, and enter the results in the following table.

 Suppose the base year for this price index is 2017.

 In the last row of the table, calculate and enter the value of the CSPI for the remaining years.

 Between 2017 and 2018, the CSPI increased by _______  %. Between 2018 and 2019, the CSPI increased by _______ .

 Which of the following, if true, would illustrate why price indexes such as the CSPI might overstate inflation in the cost of going to college? Check all that apply.

•  Energy drinks became increasingly popular on college campuses between 2017 and 2019 due to significant improvements in flavor, but this quality change is hard to measure.

•  As the price of calculators rose, fewer students decided to buy them, opting instead to use the free calculators in their cell phones or on their computers.

•  A new mobile device for personal computing became available for purchase.

•  Professors required each student to buy 10 textbooks, regardless of the price.

Answer 1

			2017		2018		2019
	Qty.	Price	Cost	Price	Cost	Price	Cost
NOtebook	10	2	20	1	10	3	30
Calculator	1	50	50	54	54	75	75
Coffee	200	1	200	1	200	1	200
Energy drink	100	2	200	3	300	4	400
Textbook	10	100	1000	120	1200	150	1500
Total cost			1470		1764		2205
Price index			100		120		150

The formula for CSPI = [cost of market basket in current year] / [cost of the basket in base year] x 100

Between 2017 and 2018, the CSPI increased by 20% and between 2018 and 2019, the CSPI increased by 25%

Price indexes such as CSPI might overstate inflation because of a number of reasons:

(i) Substitution bias

According to this, when the price of a commodity in the consumer basket increases substantially, consumers tend to substitute the goods with alternatives.

(ii) Quality bias

Over time, technological advancements result in increasing the usefulness and product life, which is not captured by CSPI.

(iii) New product bias

New products are not introduced into the market basket until they are used extensively by a large number of consumers, thus resulting in overstating.

Of the above-given reasons, (a) increase in quality of energy products, (b) substitution of calculators with mobile phones, and (c) availability of new mobile devices are all that result in overstating inflation in CSPI.

Ans. (a), (b) and (c)