CPI measures inflation at the consumer level, but there are problems with the calculation such as substitution errors, new items added to the basket of goods, and quality changes. Economists use a basket of goods to calculate CPI, but different countries may use different goods. Substitution bias, introduction of new items, and quality changes can all affect the accuracy of CPI.
CPI stands for consumer price index; it is an economic measurement that tracks inflation in an aggregate economy at the consumer level. While frequently used and commonly reported, there are some problems with the IPC. The biggest problems with CPI include substitution errors, new items added to the basket of goods, and quality changes in goods. Economists often acknowledge these problems and attempt to explain or remove these problems from calculus. While these problems may not disappear entirely, their mitigation is needed to fully explain the effects of inflation on the economy.
Economists use a basket of goods in calculating the CPI. This basket contains a specific number and type of products that economists believe most people will buy to maintain a basic standard of living. The CPI calculation looks at the change in the price of each item in the basket of goods over a specific period of time. Changes in the price of each item, both up and down, though generally up, indicate the amount of inflation for the goods. Not all economies or countries use the same goods in their baskets to calculate CPI.
Substitution bias is the first of the most common problems with CPI. The problem is that all the prices of the items in the cart – both goods and services, in most cases – don’t change by the same amount with each measurement period. Also, consumer preferences may change. For example, consumers may start to prefer steaks less as demand for clothing increases. In free-market economies, price changes can affect preference or demand for goods more than other reasons, which presents problems with the CPI since the calculation cannot explain such changes.
The introduction of new items into an economy can change the goods a consumer feels are necessary to maintain their standard of living. For example, clothes may be a traditional commodity that an individual deems important to their standard of living. Improvements in technology, however, have shifted the preference from clothes to computers. While consumers believe computers are necessary to maintain a certain standard of living, economists don’t add this item to their shopping cart. Problems with IPC occur naturally as differences in calculation do not actually correspond to reality.
Quality changes can also create problems with the IPC. The quality of the goods or services purchased typically has no place in this calculation. For example, the basic good of average quality may be in the economist’s imaginary basket of goods. Consumers, however, do not purchase this item due to the inferior quality compared to other products available. Price inflation for these favored goods never enters the CPI calculation, making the information meaningless in some cases.
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