Question

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

Short answer

Substitution bias arises when calculating the inflation rate based on a fixed basket of goods because it doesn't account for changes in consumer preferences and purchases when the prices of goods change. As prices change, consumers may substitute one good for another due to price differences or new preferences. Since the fixed basket of goods remains unchanged, it doesn't take these changes into account, leading to an overstatement of the cost of living, known as "substitution bias." This inaccurate representation can have consequences on various economic decisions and policies tied to inflation, such as adjustments in wages, pensions, and taxation.

Step-by-step solution

1. Understanding the concept of a fixed basket of goods.

A fixed basket of goods is a hypothetical set of goods and services that consumers typically purchase, used to measure price changes over time. This fixed basket is the basis for calculating price indices like the Consumer Price Index (CPI). Its content does not change, which means its composition remains the same throughout the years it is used for measurement.

2. Price changes of goods and services.

Over time, the prices of goods and services in the market tend to change. Some products might become more expensive, while others can become cheaper. This change in prices leads to consumers altering their consumption patterns. They may substitute one good for another due to price differences or new preferences.

3. The nature of consumer substitution.

When the price of a good increases relative to others, consumers may switch to substitute goods, which are relatively cheaper. This substitution reflects a shift in consumer preferences, as they adjust their consumption to maintain a similar level of satisfaction while minimizing their expenses.

4. Substitution bias in the fixed basket of goods.

Since the fixed basket of goods remains unchanged over time, it doesn't take the changes in consumer behavior and preferences into account. When consumers switch to cheaper substitutes, the fixed basket of goods overstates the changes in the cost of living due to its static composition. This overstatement of the cost of living is called "substitution bias."

5. Implications of substitution bias.

Substitution bias in the calculation of inflation results in an inaccurate representation of the changes in the cost of living. This inaccurate representation can have consequences on a variety of economic decisions and policies tied to inflation, such as adjustments in wages, pensions, and taxation. By failing to account for substitution effects, policy-makers may overestimate the impacts of inflation on the economy.