Question

The Consumer Price Index (CPI) measures the change in prices paid by urban consumers for goods and services. Urban consumers represent about 93 percent of the total U.S. population. Because the CPI uses a fixed basket of goods, there are problems that arise when new products are introduced, products are improved, or consumers switch to cheaper substitute goods when prices rise.

In the case of substitution bias, consumers tend to substitute cheaper goods for more expensive goods in response to higher prices. The CPI does not capture this behavior but rather assumes that consumers continue to buy the same, higher priced goods, thus overstating the increase in the cost of living.

Question:

When prices rise, there may be some ability to minimize the impact of higher prices, if you can substitute a less expensive alternative. Is this always possible?

Answer 1

Substituting less expensive goods to combat rising prices is not always possible, particularly for necessary goods with no close substitutes.

Step-by-step explanation:

When prices rise, there may not always be the possibility to minimize the impact of higher prices through the substitution of cheaper alternatives.

The ability to substitute depends on several factors such as the elasticity of demand for a good, the availability of substitute goods, consumer preferences, and the nature of the goods themselves. Certain goods, especially those that are considered necessities or have no close substitutes, are less likely to be swapped for cheaper options.

In the context of the Consumer Price Index (CPI), while substitution bias is a known limitation, practices such as updating the basket of goods and using alternative methods for calculation can minimize, but not eliminate, these issues.

The Bureau of Labor Statistics (BLS) has worked on incorporating substitution effects and quality improvements in the CPI to provide a more accurate measure of the cost of living and inflation. For instance, adjustments for goods like computers consider changes in speed, memory, and screen size to determine a more accurate pricing change reflective of quality improvements.

The CPI includes methods to consider substitution bias and quality improvements, but such adjustments have limitations and are subject to debate among economists.