Problems with the Consumer Price Index (CPI)

So just like most statistics and most concepts in economics C. P. I. Consumer price index is not perfect. Let's talk about some of the issues that we run into when we use C. P. I. As a measure of inflation. So some of the problems we run into with C. P. I. Is that they might overstate inflation. It might overstate inflation for some of these reasons. So we're just gonna kind of talk about these four different biases that emerge when we use C. P. I. And let's go ahead and start here with the substitution bias. So substitution bias. It talks about the idea that the same amount is being purchased each month in the C. P. I remember when we when we say this is what's in the basket of goods. Well we're going to calculate the same amount of being purchased in each month. But what happens if prices change if the price is something goes up as we've learned with our supply and demand? If those prices are going up we're probably gonna substitute to buy something else instead. Right? So if we see the price of apples start to shoot up people are gonna be unlikely to buy as many apples. Right. However the CPI I. Calculation is going to assume that the same amount of apples are being bought. So what's that gonna do? It's gonna overstate inflation Right because it's showing that people are still buying the same amount of apples at this higher price where instead people were buying instead of apples they started buying oranges or some other fruit instead. Right So as the prices rise for apples, apples go up I'll do price of apples goes up. The quantity of apples goes down right just like we saw with law of demand the price of apples go up. The quantity of apples demanded will go down. Alright. So people will start substituting to buy other things. So although the problem here with the C. P. I. Is that it's going to say that the purchases remain constant so it's going to overstate the actual price of the basket because it's keeping the basket constant when in fact people are actually changing what they put into their basket because of these rising prices. Let's go on to the next one. The quality bias here. So what's the quality bias that over time the quality of items tends to increase? Right? Technology is increasing the way we produce things is getting better. So we would think that the quality of items is getting better over time. So what what do you think happens when we have higher quality items? Generally the price goes up when we have higher quality items. When we've got faster computers, faster cellphones right? The prices start going up. So these quality improvements they're embedded into the price. However when we think about cp I they're just saying oh we're buying the same thing. They're thinking that the cell phone that we bought five years ago is the same as the cell phone when we bought now. However we're paying for a different thing with the cell phone now. Right. We're buying the better technology, the touch screen technology, the app, the app integration that it has. Right? So these quality improvements, they're embedded into the price. However when the basket looks at it it just says cellphone price was this at this time cellphone prices much higher. Now that must be because of inflation. However part of that is also going to be because of the quality improvement. So the price may have increased due to quality may have increased due to quality as well, not just inflation. However, the C. P. I is just looking at the price change as inflation. Let's go on to the next one new product Bias. So when there's new products that are being introduced so such as when the cell phone was introduced, it may not be included in the basket and that's exactly what happened in the 90s. Cell phones were not included in CPI I until the late 90s. Okay so millions of cellphones were in use and they were quite expensive when they first came out And then the prices started to drop and then obviously we've started to see increases in cell phone prices again as they got more technologically advanced with apps and touch screen all of this like we like we talked about um but what does tend to happen when a new technology comes out such as when the DVD player came out or HD TVs, They were really expensive when they came out and they weren't included in the basket. But those prices tend to decrease over time as the technology gets better, production gets a little better of them. Um We'll see that the price actually starts to decrease a little bit after their first introduced. However these price decreases will not reflect in C. P. I. So we're actually seeing some decreases in prices that are actually beneficial for the customer and which would lower technically the price level. However since those products are not in the basket, these new products such as when the DVD player came out, it wasn't included. Well then that's not going to be included in the CPI I calculation. So it's gonna overstate inflation again right because it's not taking into account these price decreases. Finally we have outlet bias and this is a relatively new one where the way people shop has changed over time. So generally people shopped in breaking border stores, they go to the store, they buy whatever they want. But of course now the first thing that happened was people started buying at a discount chains so they go to Costco or Sam's club and they would buy in bulk to save some money. So if the C. P. I. Calculation had you buying toilet paper and they had you buying it at just the grocery store for a higher price. However people were now going to discount stores and buying you know pallet full of toilet paper for a lower price. Well that would affect the price they're actually paying for these goods. Right So the C. P. I. Calculation would be taking this grocery store price instead of this discount price that people were actually paying. And of course this has changed again online with people using services like amazon amazon prime too to purchase their home goods and generally get it at a at a cheaper price. So when they're calculating CPI I they if they're using these store prices rather than the actual prices people are paying that might be a little lower. Well it's again going to inflate uh overstate inflation right? It's gonna think that people are paying more than they actually are. So these are some of the problems that come up with C. P. I. Again when we study C. P. I. These could come up in some you know random multiple choice questions. But the main thing you want to know is how to calculate CPI. I. It's still very important calculation for this test and how we use it to calculate inflation as well. Cool. Alright. That's about it for this video. Let's go ahead and move on to the next one.