Question

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

Short answer

The "quality/new goods bias" arises in calculating the inflation rate based on a fixed basket of goods because this method does not account for changes in product quality or introduction of new products. This can lead to overestimation or underestimation of the actual inflation rate, which can misrepresent the cost of living for consumers. To remedy this, it's important to periodically update the fixed basket of goods and make adjustments for quality improvements.

Step-by-step solution

Understand Fixed Basket of Goods

A fixed basket of goods is a method used to calculate the inflation rate by comparing the price of a set of goods and services over time. This basket represents a sample of goods and services typically consumed by households and is used as a benchmark to measure the change in prices over time. The Consumer Price Index (CPI) is a widely used measure of inflation that is based on a fixed basket of goods.

Understand Quality/New Goods Bias

Quality/New Goods Bias arises when the fixed basket of goods does not take into account changes in the quality of the products or the introduction of new products. This can lead to an overestimation or underestimation of the inflation rate depending on the impact of the quality improvements or new products on overall prices. This bias occurs because the prices of goods are not adjusted for changes in quality, and new products are not included in the fixed basket of goods.

Provide an Example

Let's consider a simple example: If a fixed basket of goods includes a basic mobile phone and the prices of this mobile phone have remained stable over time, the calculated inflation rate based on this fixed basket will show little to no change. However, the mobile phone market has significantly evolved, with new smartphones offering advanced features at higher prices. These new smartphones are not included in the fixed basket, which causes a quality/new goods bias in the calculated inflation rate. Consumers who buy these new smartphones might experience a higher personal inflation rate compared to the calculated CPI and it can cause a misrepresentation of the actual increase in the cost of living.

Summarize the Explanation

In conclusion, the "quality/new goods bias" arises when we calculate the inflation rate based on a fixed basket of goods, as this method does not account for changes in quality or new products being introduced to the market. These factors can lead to a misrepresentation of the true inflation rate or the cost of living experienced by consumers. This highlights the importance of updating the fixed basket of goods periodically and making adjustments for quality improvements to more accurately measure the inflation rate.