Question

Suppose that consumers consider tea and coffee to be substitutes. When the price of tea increases, consumers purchase less tea and more coffee. When the CPI is calculated following the increase in the price of tea, it takes into account:

Option 1: Only the price change of tea
Option 2: Both the price changes of tea and coffee
Option 3: Only the quantity change of tea
Option 4: Neither the price changes nor the quantity changes of tea and coffee

Answer 1

Option 2: Both the price changes of tea and coffee are considered when calculating the CPI as tea and coffee are substitute goods, and consumers will likely consume more coffee when the price of tea increases.

Step-by-step explanation:

When the Consumer Price Index (CPI) is calculated following an increase in the price of tea, where tea and coffee are considered substitute goods, the CPI takes into account both the price changes of tea and coffee. This is because the substitution effect occurs when consumers, due to an increase in the price of one good (tea), shift their consumption towards a substitute good (coffee) that is relatively cheaper.

The same occurs with complementary goods when a price change induces the opposite effect. Furthermore, these behaviors are reflected in the CPI, which attempts to measure changes in the cost of living and would need to account for changes in consumer habits due to price fluctuations. Hence, the correct option is Option 2: Both the price changes of tea and coffee are taken into account.In this scenario, when the price of tea increases, consumers purchase less tea and more coffee. This is because tea and coffee are substitute goods, meaning that they can be used interchangeably. When the price of tea goes up, consumers switch to purchasing more coffee as a substitute.