HAT Manifesto Part 1/3 - Rubric Cube - 250803 edit

 

Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.

PART 8 The Data of Macroeconomics

Chapter 24 of 36 Measuring The Cost of Living

Section 6 of 18

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Table A here

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The consumer price index (CPI) is used for measuring changes in the cost of living.

The CPI determines how much incomes must rise to maintain a constant standard of living.

Three problems with calculating the CPI are

-1- substitution bias

-2- introduction of new goods bias

-3 - unmeasured quality change bias

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-1- Substitution Bias

When prices change each year they all do not change proportionately, some prices rise more than others

Consumers respond to these unequal price changes by

· buying less of the goods whose prices have risen

· buying more of the goods whose prices have risen less or fallen

If a price index is computed assuming a fixed basket of goods, it

· ignores consumer substitution

· overstates the yearly cost of living increase

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Consider a situation of a basket of apples and pears, Table A.

In the base year 1 apples are cheaper than pears, so consumers buy more apples than pears.

The Bureau of Labor Statistics (BLS) designates the basket of goods with 2 apples and 1 pear.

The next year pears become cheaper than apples.

Consumers respond by buying more pears and fewer apples.

But the BLS uses a fixed basket, which assumes consumers continue buying the now more expensive apples in the same quantities as before.

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Because of this substitution the index will measure a larger increase in the cost of living than consumers actually experience.

In the case of Table A, there has actually been no increase in the cost of living, in year 2 it remains $4 with zero inflation.

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