Consumer Price Index and the Substitution Bias

Consumer Price Index and the Substitution Bias
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  • 0:04 Estimating Prices
  • 1:05 Inflation
  • 1:35 Consumer Price Index
  • 2:25 The Substitution Bias
  • 2:51 The Law of Demand
  • 3:24 The Substitution Effect
  • 4:54 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In this lesson, you'll learn about the Consumer Price Index and how it is measured. You'll also learn why many economists believe that the Consumer Price Index overstates inflation.

Estimating Prices

I want you to imagine now that you're entering a grocery store, and as you walk in, you happen to look down at the grocery shopping list that you scribbled on a piece of paper before you left home. Now, I certainly would hate for you to look at my list because, truth be told, it's hard to read my writing. It kind of looks like a doctor's writing. But we're assuming that in your case, everything is nice and neat. On your shopping list are things like bread, spinach, and tangerines.

Now, although you didn't write this on your list, you have a certain brand of bread you always buy. You tend to choose the same brand of spinach as well. You also tend to buy tangerines each week, but you also like oranges just as much. Well, the prices for goods change over time. If the price of oranges goes down far enough, even though you wrote 'tangerines' on your shopping list, you'd be willing to buy oranges instead. This truth makes it difficult for economists and the government to estimate how much prices are going up. Let's talk about why.

Inflation

Inflation refers to a sustained increase in the level of prices in an economy. When the government reports that inflation was 3% this year, let's say, then that means that prices, on average, increased by 3% across the economy. It also means that a $1 bill in your pocket is worth 3% less than it was last year, because when prices go up, you're not able to afford the same amount of goods and services that you could before.

Consumer Price Index

One of the ways the government measures inflation is by creating a benchmark each year of the prices that consumers pay for stuff. It's called the Consumer Price Index.

The Consumer Price Index, or CPI for short, represents a fixed basket of goods whose prices the Bureau of Labor Statistics measure each year. Tens of thousands of prices go into the creation of the Consumer Price Index, but at the end of the day (well, in the morning also), they're estimating what they think people are buying across the nation. Once they come up with an estimate of the basket of goods that an average citizen buys, they keep this basket and check the prices of the stuff in this basket each and every year.

The Substitution Bias

However, a weakness exists in this index that economists have come to recognize. We call it the substitution bias.

The substitution bias is a weakness in the Consumer Price Index that overstates inflation because it does not account for the substitution effect, when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy.

The Law of Demand

To explain this effect, you have to revisit one of the basic foundations of economics, the law of demand.

According to the law of demand, all other things equal, if the price of a good or service goes up, the demand for it will decrease, and the opposite is also true. If the price of a good or service goes down, the demand for it will increase. This is what makes the demand curve downward-sloping.

A graph of the demand curve
Demand Curve Graph

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