Problems with the CPI

While the CPI is a convenient way to compute the cost of living and the relative price level across time, because it is based on a fixed basket of goods, it does not provide a completely accurate estimate of the cost of living. Three problems with the CPI deserve mention: the substitution bias, the introduction of new items, and quality changes. Let's examine each of these in detail.

Substitution Bias 

The first problem with the CPI is the substitution bias. As the prices of goods and services change from one year to the next, they do not all change by the same amount. The number of specific items that consumers purchase changes depending upon the relative prices of items in the fixed basket. But since the basket is fixed, the CPI does not reflect consumer's preference for items that increase in price little from one year to the next. For example, if the price of backrubs in Country B jumped to $20 in time period 4 while the cost of bananas remained fixed at $3, consumer would likely purchase more bananas and fewer backrubs. This intuitive phenomenon of consumers substituting purchase of low priced items for higher priced items is not accounted for by the CPI. 

Introduction of New Items

The second problem with the CPI is the introduction of new items. As time goes on, new items enter into the basket of goods and services purchased by the typical consumer. For example, if in time period 4 consumers in Country B began to purchase books, this would need to be included in an accurate estimate of the cost of living. But since the CPI uses only a fixed basket of goods, the introduction of a new product cannot be reflected. Instead, the new items, books, are left out of the calculation in order to keep time period 4 comparable with the earlier time periods.

Quality Changes

The third problem with the CPI is that changes in the quality of goods and services are not well handled. When an item in the fixed basket of goods used to compute the CPI increases or decreases in quality, the value and desirability of the item changes. For example, if backrubs in time period 4 suddenly became much more satisfying than in earlier time periods, but the price of backrubs did not change, then the cost of living would remain the same while the standard of living would increase. This change would not be reflected in the CPI from one year to the next. While the Bureau of Labor Statistics attempts to correct this problem by adjusting the price of goods in the calculations, in reality this remains a major problem for the CPI.