Question

Describe major problems with CPI as an indicator inflation, give examples of each

Answer 1

CPI means consumers price index which calculates the change in the prices of the goods and services purchased by the consumers.

There are certain drawbacks of CPI as an indicator of inflation:

1. Does not consider substitution effect: CPI doesn't consider the fact that people shift choices to other substitution goods available if price of a particular good increases. For example people start buying regular gasoline when the price of the premium one increases.

2. Does not consider innovation or change in quality: CPI doesn't measure the change in the quality of the product leading to increase in price. It will only measure the change in price. So even if the consumers' net benefit has increased due to change in quality, CPI will not measure that. For example if the price of cereals increase because of using better quality ingredients, CPI will not measure the increase in quality which satisfies the customers more but will only measure the change in price.

3. Too much weight on urban consumption: CPI measures the prices of goods consumed in the urban areas. It doesn't take into consideration the prices of the goods consumed in suburban or rural areas. For example price of one product might be lesser in urban area but more in backward areas because of lack of accessibility and proper transportation means.