Inflation

Consumer Price Index Biases

The CPI may overstate inflation because of substitution, new product, and quality biases.
The CPI is used to determine whether the U.S. economy is experiencing inflation. However, the CPI may not show the whole picture because of CPI biases. A CPI bias is a way in which the CPI does not fully take into account the entirety of the economic situation.

The CPI may overstate inflation, sometimes by as much as 1%. This can happen because of biases, including substitution bias, quality bias, and new-product bias. For example, the fixed basket of goods and services used to find the CPI includes cars. Suppose that in one year, many people buy American-made cars, but the next year, the price of American cars goes up. That year, people buy less expensive foreign-made cars instead. This is an example of substitution bias, the tendency to buy less expensive alternatives when prices change. Inflation can lower people's standards of living because rising prices mean people cannot afford as much as they used to (if their wages do not increase as well). However, the actual effect of rising prices on the standard of living is less than inflation suggests because people can substitute less expensive options.

Quality and new-product biases also affect the CPI. Quality bias refers to the tendency to ignore changes in the quality of products when calculating a price index. For example, technological improvements often decrease the costs of goods by making them more efficient (e.g., flat-panel TVs, cell phones, and tablets). New-product bias, the tendency to not count new goods as part of a price index, occurs because the CPI fixed basket includes commonly used goods and services. New products are not commonly used yet, so they are not included, which also means that their effects on prices (such as price decreases because of technology) also do not show up in the CPI.