Final answer:
The market basket approach uses a fixed basket of goods to measure changes in price levels and the cost of living, which can lead to substitution bias and quality/new goods bias due to changes in consumer behavior.
Step-by-step explanation:
The market basket approach is a method used by government statisticians, such as those at the U.S. Bureau of Labor Statistics, to calculate economic indicators like the Consumer Price Index (CPI). This approach uses a fixed basket of goods and services to track changes in price levels and cost of living over time. By keeping the contents of the basket constant, statisticians can compare the total cost of these goods and services between different periods. However, this approach does not account for changes in consumer behavior, such as the tendency to substitute goods when prices change, known as substitution bias, or the introduction of new goods and improvements in quality, known as quality/new goods bias.
To illustrate, consider a scenario where the cost of a fixed basket of goods has risen by 25% over a decade, and your salary has increased by the same percentage. Does this mean your standard of living has stayed the same? Not necessarily, since you likely adjust your consumption habits over time in response to price changes, substituting more expensive goods for cheaper alternatives, and taking advantage of new and improved products. Therefore, the increase in the cost of a fixed basket might overstate the true change in cost of living. To reduce these problems, economists must consider consumer behavior in their measures.