5.9 The Flaws in the Consumer Price Index

Consumer Price Indexes that employ fixed market baskets are likely to overstate inflation (and understate deflation) for four reasons:

1. Because the components of the market basket are fixed, the index does not incorporate consumer responses to changing relative prices.
2. A fixed basket excludes new goods and services.
3. Quality changes may not be completely accounted for in computing price-level changes.
4. The type of store in which consumers choose to shop can affect the prices they pay, and the price indexes do not reflect changes consumers have made in where they shop.

To see how these factors can lead to inaccurate measures of price-level changes, suppose the price of chicken rises and the price of beef falls. The law of demand tells us that people will respond by consuming less chicken and more beef. But if we use a fixed market basket of goods and services in computing a price index, we will not be able to make these adjustments. The market basket holds constant the quantities of chicken and beef consumed. The importance in consumer budgets of the higher chicken price is thus overstated, while the importance of the lower beef price is understated. More generally, a fixed market basket will overstate the importance of items that rise in price and understate the importance of items that fall in price. This source of bias is referred to as the substitution bias.

The new-product bias, a second source of bias in price indexes, occurs because it takes time for new products to be incorporated into the market basket that makes up the CPI. A good introduced to the market after the basket has been defined will not be included in it. But a new good, once successfully introduced, will likely fall in price. For example, when VCRs were first introduced, they generally cost more than $1,000. Within a few years, an equivalent machine cost less than $200. But when VCRs were introduced, the CPI was based on a market basket defined in the early 1970s. There was no VCR in the basket, so the impact of this falling price was not reflected in the index. The DVD player was introduced into the CPI within a year of its availability.

A third price index bias, the quality-change bias, comes from improvements in the quality of goods and services. Suppose, for example, that Ford introduces a new car with better safety features and a smoother ride than its previous model. Suppose the old model costs $20,000 and the new model costs $24,000, a 20% increase in price. Should economists at the Bureau of Labor Statistics (BLS) record the new model as 20% more expensive than the old one? The new model is not the same product as the old model. BLS economists faced with such changes try to adjust for quality. To the extent that such adjustments understate quality change, they overstate any increase in the price level.

The fourth source of bias is called the outlet bias. Households can reduce some of the impact of rising prices by shopping at superstores or outlet stores (such as T.J. Maxx, Wal-Mart, or factory outlet stores). However, this often means they get less customer service than at traditional department stores or smaller retail stores. However, since such shopping has increased in recent years, it must be that for their customers, the price reduction has been more valuable to them than loss of service. Prior to 1998, the CPI did not account for a change in the number of households shopping at these newer kinds of stores in a timely manner, but the BLS now does quarterly surveys and updates its sample of stores much more frequently. Another form of this bias arises because government data collectors do not collect price data on weekends and holidays when many stores run sales.

According to the Bank of Canada, a total CPI bias in Canada is roughly 0.5 percentage points per year, with an upper bound of about 0.6 percentage points per year. From this total, slightly more than half seems to result from the CPI basket being fixed.