Question at position 24 A criticism of the consumer price index as a measure of the cost of living is that it 4MAM1overstates the rate of inflation to compensate for statistical errors in data collection understates the rate of inflation because it reflects the increase in prices due to the introduction of new goodsunderstates the rate of inflation because it only considers spending by typical urban consumersoverstates the rate of inflation because it ignores consumers’ ability to substitute among similar items when prices changeunderstates the rate of inflation because the base year is outdated

Question

BlackTom AI · Accepted Answer

CPI's fixed-basket construction causes substitution bias: when relative prices change, consumers buy more of relatively cheaper goods, but the traditional CPI keeps quantities fixed and therefore overstates the cost of maintaining the original basket.

1. Relevant knowledge points and concepts
- Consumer Price Index (CPI) measures the cost of a fixed basket of goods and services over time (Laspeyres-type index).
- Substitution bias occurs because CPI assumes consumers purchase the same quantities even when relative prices change; in reality, consumers substitute toward cheaper alternatives.
- Other known CPI biases include new-good bias, quality change, and outlet substitution, but substitution bias specifically leads to overstatement of inflation.

2. Complete reasoning process step by step
- CPI uses a fixed basket determined in a base period; when the price of one good rises, CPI counts the higher cost to maintain that base basket.
- Consumers respond to higher relative prices by shifting purchases to less expensive substitutes, reducing their true increase in cost of living.
- Because CPI does not fully reflect this substitution, it attributes a larger rise in the cost of living than consumers actually experience.

3. Numerical illustration (intermediate steps)
- Base period: consume 1 unit of Good A and 1 unit of Good B; prices P_A = $1, P_B = $1. Cost = 1*1 + 1*1 = $2.
- New prices: P_A = $2, P_B = $1. Fixed-basket CPI cost = 1*2 + 1*1 = $3 (50% increase).
- If consumers substitute (buy 0 A and 2 B because B is cheaper), actual spending = 0*2 + 2*1 = $2 (0% change).
- CPI indicates 50% inflation while actual consumer cost did not rise — CPI overstates inflation.

4. Why the correct answer is correct
- The correct option states CPI overstates inflation because it ignores consumers’ ability to substitute among similar items. This directly captures substitution bias: fixed weights cause measured price increases to be larger than the real rise in the cost of living when substitution occurs.

5. Why the other options are incorrect
- “Overstates ... to compensate for statistical errors” is unsupported and vague; CPI does not deliberately overstate for compensation.
- “Understates ... due to introduction of new goods” is wrong: new goods often create measurement problems that typically cause upward bias (omitted or delayed inclusion can misstate value), not a clear understatement.
- “Understates ... only considers typical urban consumers” mischaracterizes coverage: CPI-U covers urban consumers, and that limitation is a coverage issue, not a reason CPI understates inflation.
- “Understates ... because the base year is outdated” is incorrect; an outdated base year affects comparability but not in the specific direction claimed, and the main well-documented bias is upward (overstatement), not systematic understatement.

6. Conclusion and confirmation
- Therefore, the CPI overstates the rate of inflation because it ignores consumers’ ability to substitute among similar items when prices change. This matches the provided correct answer.

Similar Questions

Substitution bias occurs because the CPI ignores the possibility of consumer substitution toward goods that have become relatively less expensive.

Which of the following trees corresponds to a potential parse of the ambiguous sentence below, with correct syntactic categories? Some diagnostics are provided.

Which of the following sentences contain two non-finite verbs? Select all that apply.

Analyze the following sentence: The sentence contains [ Select ] 8 6 5 7 3 4 functional words, [ Select ] 2 3 1 4 5 count nouns, [ Select ] 4 5 2 1 3 mass nouns, and [ Select ] 1 5 2 3 4 adjectives.

You own a bond that pays $64 in interest annually. The face value is $1,000 and the current market price is $1,021.61. The bond matures in 11 years. What is the yield to maturity?

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler