Question

Economists in the Statistics Bureau decide to check the CPI substitution bias. To do​ so, they conduct a Consumer Expenditure Survey in both 2015 and 2016.

The table shows the results of the survey. It shows the items that consumers buy and their prices.

The Statistics Bureau fixes the reference base year as 2015.

Is there a substitution bias in the CPI that uses the 2015​ basket? Explain.

A commodity substitution bias​ _______ when the CPI is calculated in 2016 using the 2015 basket.

The reason is that​ _______.

A.​exists; people switch from the relatively more expensive pasta to the relatively less expensive pizza

B.does not​ exist; pizza and pasta are not substitutes

C.​exists; over time preferences change and people prefer to eat pizza rather than pasta

D.does not​ exist; the CPI market basket is updated frequently to eliminate substitution bias

The CPI that uses the 2015 basket​ _______ the inflation rate in 2016.

A.is better than the CPI that uses the 2016 basket

B.understates the inflation rate in 2016

C.calculates the same inflation rate as the CPI that uses the 2016 bask

D.overstates the inflation rate in 2016

2015 Quantity Price 2016 Quantity Price Item 20 $3 Pizza Pasta

Answer 1

The substitution bias takes place when the substitution effect is not being considered, due to which consumers substitute one good for another after it becomes cheaper than the goods which are normally bought by the customer.

A commodity substitution bias​ exists when the CPI is calculated in 2016 using the 2015 basket. The reason is that people switch from the relatively more expensive pasta to the relatively less expensive pizza.

The CPI that uses the 2015 basket​ _understates the inflation rate in 2016.

This is because the price of pastas have increased in 2016.