Chapter 9: Problem 14

Why does "substitution bias" arise if we calculate the inflation rate based on a fixed basket of goods?

Short Answer

Expert verified

Substitution bias arises in the calculation of the inflation rate based on a fixed basket of goods because it doesn't account for changes in consumers' preferences or the availability of new products. When prices of items in the fixed basket increase, consumers may substitute them with cheaper alternatives or newer products. However, the fixed basket remains unchanged, leading to an overestimation of the inflation rate by not reflecting actual consumption patterns. This occurs as the fixed basket overstates the increase in the cost of living without adapting to consumer preference changes or the introduction of new products.

Step by step solution

Understand a Fixed Basket of Goods

A fixed basket of goods is a set of items with predetermined quantities and fixed prices in the base year. It is used to calculate the Consumer Price Index (CPI), a measure of the average price change of a basket of consumer goods and services over time, which further helps in estimating the inflation rate. The fixed basket of goods is used as a benchmark to compare price changes, however, it may not be an accurate representation of consumption patterns over time.

Define Substitution Bias

Substitution bias occurs when the calculation of the inflation rate based on a fixed basket of goods doesn't take into account the changes in consumers' preferences or the availability of new products over time. When the prices of some items in the fixed basket increase, consumers may substitute them with cheaper alternatives or newer and better products. However, the fixed basket remains unchanged, which leads to an overestimation of the inflation rate by not reflecting the actual consumption patterns.

Explain the Reason for Substitution Bias

Substitution bias arises in the calculation of the inflation rate based on a fixed basket of goods because the fixed basket doesn't adapt to the changes in consumers' preferences or the introduction of new products. Consumers respond to price changes and substitute goods with more suitable or cost-effective options. Since the fixed basket remains unaffected by these changes, it overstates the inflation rate by overstating the increase in the cost of living.

Illustrate with an Example

For example, consider a scenario in which a fixed basket of goods includes 5 units of product A and 5 units of product B. Due to an increase in the price of product A, consumers shift their preferences and start buying 3 units of product A and 7 units of product B, which is now a more cost-effective option. However, the fixed basket still calculates the inflation rate based on the original quantities (5 units of A and 5 units of B). As a result, the inflation rate calculated using the fixed basket of goods overstates the increase in the cost of living and doesn't accurately reflect the consumers' actual consumption patterns, leading to substitution bias.

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