Question

9. Describe the three problems that make the CPI an imperfect measure of the cost of living.

Answer 1

The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.

Substitution bias- The basket is unchanged to reflect customer response to relative price changes. Consumers take the advantage of comparatively less costly products. The index exaggerates the rising cost of living by not considering replacement for the market.

Introduction of new goods- The basket doesn't reflect the change in purchasing power brought on by the launch of new goods. New innovations result in greater variety, which in effect adds value to every dollar. To order to sustain any given standard of living, customers need fewer dollars.

Unmeasured quality changes- When a good's quality improves from one year to the next, the value of a dollar increases, even though the good's price remains the same. When the quality of a good decreases from one year to the next, the value of a dollar increases, even though the price of the good remains the same, although these variations are difficult to quantify.