Answer to Question #233989 in Macroeconomics for mustafa

Question

Review the discussion of bias in the CPI. Explain why failure to consider the quality improvement of a

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

The consumer price index is the most appropriate tool commonly used measure of levels of price and inflation state in a country. CPI is used to measure the change in the prices of a fixed basket of goods over some time of the current year relative to the chosen base year. Usually, a higher and increasing CPI is a clear indicator of the persistent increase in the inflation rate. CPI, despite being a very appropriate measure it has a great deal of bias. CPI does take a holistic approach to study the whole economic situation in a country at a time. It overstates the inflation rate through biases in its quality, substitution, outlet and product choice. CPI does consider the qualities of a product, but instead, it only looks at the price increase or decrease of a product. The failure to consider product quality and all improvements done in the production of new products has led to an increasingly upward bias in the determination of the trend CPI assumes over time. For example, advancements in modern technology have led to continuous improvement in the quality of products manufactured and their useful life. These improvements are not taken care of nor considered by the CPI. For instance, due to innovations and inventions, tires used in the automobile industry have become more efficient with improved quality. This has subsequently led to an increase in the prices of those improved and high-quality tires. A casual comparison of the prices in two periods, say 2000 and now 2021 are very different. In the year 2000, prices were a bit low compared to 2021, when the prices of tires are very high due to quality improvement and an increase in the rate of inflation and changing technological world. Modern tires in the 21^st century come with numerous advantages, such as improved traction, better fuel consumption, improved performance, and gives drivers a superb driving experience as they are much comfortable compared to those tires manufactured and sold in the 2000s. CPI overlooks the quality of the tires manufactured in the year 2021 and instead only looks at the price and compares it with the price of the base year, let us say 2000. This has led to the emergence of quality bias. The quality of modern tires is much underestimated, and the inflation rate is overestimated, thereby proving false, wrong and malicious economic indication that is not the accurate picture of the product.