Chapter 2 MEASURING THE COST OF LIVING

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Problems in Measuring the Cost of Living

a. Substitution Bias

1) When the price of one good changes, consumers often respond by substituting another good in its place.

2) The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services.

3) This implies that the CPI overstates the increase in the cost of living over time.

b. Introduction of New Goods

1) When a new good is introduced, consumers have a wider variety of goods and services to choose from.

2) This makes every dollar more valuable, which lowers the cost of maintaining the same level of economic well-being.

3) Because the market basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket.

c. Unmeasured Quality Change

1) If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises.

2) Attempts are made to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure.

d. The size of these problems is also difficult to measure.

e. Most studies indicate that the CPI overstates the rate of inflation by approximately one percentage point per year.

f. The issue is important because many government transfer programs (such as Social Security) are tied to increases in the CPI.