CPI stands for consumer price index; it is an economic measurement that tracks inflation in an aggregate economy at the consumer level. Though frequently used and commonly reported, there are some problems with CPI. The biggest problems with CPI include substitution bias, new items added to the basket of goods, and quality changes in goods. Economists often recognize these issues and attempt to explain or remove these problems from the computation. Though these problems may not completely go away, their mitigation is necessary to fully explain the effects of inflation on the economy.
Economists use a basket of goods when calculating CPI. This basket contains a specific number and type of products that economists believe most individuals will purchase to maintain a basic standard of living. The CPI computation looks at the change in price for each item in the basket of goods for a given time. Changes in each item’s price — whether up or down, though usually up — indicate the amount of inflation for the goods. Not all economies or countries use the same goods in their baskets to compute CPI.
Substitution bias is the first of the most common problems with CPI. The issue is that all prices for the items in the basket — both goods and services, in most cases — do not change by the same amount at each measurement period. Additionally, consumer preference may change. For example, consumers may begin preferring less steak, while the demand for clothes goes up. In free market economies, price changes may affect the preference or demand for goods more than other reasons, which present problems with CPI as the calculation cannot explain these changes.
The introduction of new items into an economy can change which goods a consumer deems necessary to maintain his or her standard of living. For example, clothes may be a traditional good that an individual deems important for his or her living standard. Improvements in technology, however, have shifted the preference from clothes to computers. While consumers deem computers as necessary to maintain a certain standard of living, economists do not add this item to the basket. Problems with CPI naturally occur as the differences in the computation do not actually match reality.
Quality changes can also create problems with CPI. The quality of goods or services purchased typically has no place in this calculation. For example, the basic good of average quality may be in the economist’s fictional basket of goods. Consumers, however, do not purchase this item due to inferior quality when compared to other available products. The price inflation for these preferred goods never enter the CPI computation, making the information meaningless in some cases.