Question

What are the three issues st the center of the debate regarding the accuracy of the CPI? gove examples of each issue

Answer 1

Consumer Price Index(CPI) measures average changes over time in the prices paid by urban consumers for a market basket of consumer goods and services.It is one of the most widely used tool to indicate inflation and deflation in an economy, yet it is argued that it does not give perfect measure of inflation and cost of living. The three major issues are:

1. Substitution bias - When the price of a product in consumer basket increases substantially, they tend to substitute to lower priced alternatives. The basket does not change to reflect consumer substitution of less expensive product. It instead presents numbers assuming consumers are continuing to buy the same amount of increasingly expensive goods. Thus, the index overstates the increase in cost of living by not considering consumer substitution.For example, if the price of oranges increase too much, the consumers would switch to other fruit choices.

2. Introduction of new goods - New products are not included in index until they become commonplace so the less expensive new products(due to better technology) are not reflected. Also new products bring greater variety in market, which makes consumer money more valuable increasing their purchasing power and maintaining standard of living at lower costs.Also new products are added to customer basket and increase expenditure which CPI does not account for. For example, the launch of latest android smartphone in market with best features and outlook. It would not be reflected in CPI when it is launched. Launching of this would provide better phone options to consumers and also the price of older phones would decline.CPI does not consider how new goods offer better value for money.

3. Unmeasured quality changes - With the passage of time, there is great advancement in science and technology which aid in producing higher quality products. The technological developments increase the life and usefulness of a product. When the quality improves, it provides better value for the money to consumers, even at the same price. And even if the price increases, the customers enjoy additional value of the product. But CPI does not include such improvements. For example - The increase in price of air conditioners because of improved quality that performs faster cooling and saves more power(electricity). CPI would reflect the increase in price of AC but not that the it has added more value to consumers by saving more electricity.

Also, because the CPI is purposely constructed with a focus on the buying habits of urban consumers, it has often been criticized as not providing an accurate measure of either prices of goods or consumer buying habits for more rural areas. The CPI also does not provide separate reports according to different demographic groups. Thus, CPI overstates the inflation.