Answer to Question #230287 in Macroeconomics for aqlama

Question

Review the discussion of bias in the CPI. Explain why failure to consider the quality improvement of new good leads to an upward bias in the trend of the CPI. Pick a good you are familiar with. Explain how its quality has changed and why it might be difficult for a price index to capture the increase in quality.

Answer 1

Solution:

The Consumer Price Index (CPI) is the value of a market basket in the current year with respect to its value in the base year. The bias in CPI is a way in which it does not fully take into account the entirety of the economic situation. The CPI is an imperfect measure of the cost of living as it may overstate inflation by more than one percent due to biases such as substitution biases, new-product bias, and quality change bias.

Failure to consider the quality improvement of new goods leads to an upward bias in the trend of the CPI since it results in improper adjustment of prices. That is when the quality change is not accurately identified and separated from the price change. This is because many products in the consumer basket are subject to permanent improvement because of rapid technological changes creating a challenge for price comparison.

An example of a good whose quality has really changed is the flat-panel TVs. Due to technological improvements which have decreased the costs of the goods, the goods are more advanced and efficient, including being fully equipped with more product features. Therefore, it becomes very hard for CPI to measure the changes in the quality of the flat-panel TVs. Hence, it will normally fail to take into account the improved quality of the flat-panel TV and simply note its increase in price, the price rice of which will be taken as inflation.