Question

Which of the following is a valid criticism of the consumer price index (CPI)?

• A. The CPI understates the burden of inflation on households because households can substitute cheaper goods for more expensive goods when prices increase
• B. The CPI overstates the actual burden of inflation because people can look around costlessly for cheaper goods when prices increase.
• C. The CPI overstates the burden of inflation on households because households can substitute cheaper goods for more expensive goods when prices increase.
• D. The CPI understates the actual burden of inflation because the price changes are due to quality improvements.

Answer 1

The correct option is C

The CPI overstates the burden of inflation on households because households can substitute cheaper goods for more expensive goods when prices increase.

Substitution bias occurs in the CPI because when prices of goods increase, people look for cheaper alternatives and buy those cheaper alternatives. This switch means their cost of living might not increase. However, the CPI ignores the possibility of substitution and assumes that people will continue to buy the same, more expensive goods, overstating the increase in the cost of living.