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

Question

BlackTom AI · Accepted Answer

The CPI uses a fixed basket of goods and services (a Laspeyres-type index), so it does not fully account for consumers switching purchases toward relatively cheaper substitutes; this is the essence of substitution bias.

1) Relevant concepts
- Consumer Price Index (CPI): measures the cost of a fixed basket of goods and services purchased by consumers in a base period.  
- Substitution bias: occurs when consumers change their consumption patterns in response to relative price changes but the CPI’s fixed basket does not reflect those changes.  
- Laspeyres index property: using base-period quantities means increases in prices of some items overstate the increase in the cost of maintaining the consumer’s welfare if consumers can substitute.

2) Step-by-step reasoning
- The CPI calculates price change by holding quantities constant from the base period.  
- If the price of Good A rises but Good B becomes relatively cheaper, rational consumers buy more of B and less of A.  
- Because the CPI still weights the basket with the original quantity of A, it overstates the extra money households need to purchase the base-period basket, ignoring savings from substitution.

3) Illustrative calculation (intermediate steps)
- Base-period basket: 1 apple + 1 orange at $1 each → cost = $1 + $1 = $2.  
- New prices: apple $2, orange $0.50. Cost of fixed basket = $2 + $0.50 = $2.50 (a 25% increase).  
- If a consumer substitutes toward oranges and buys 0 apples + 2 oranges to obtain two units of fruit, cost = 2 × $0.50 = $1.00 (a 50% decrease).  
- This extreme example shows the fixed-basket CPI can greatly misrepresent the actual change in cost when substitution occurs.

4) Why the correct answer is correct
- The statement matches the standard definition: CPI ignores the possibility of substitution toward relatively cheaper goods, producing substitution bias (typically causing CPI to overstate the true cost-of-living increase).

5) Why the other option (False) is incorrect
- Claiming False would assert CPI accounts for substitution; in fact, the standard CPI does not adjust for this unless replaced by chained measures. Thus False is incorrect.

6) Conclusion
- Therefore the correct answer is True, which matches the provided answer.

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

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