Lesson preview · Price Indexes
Problems with CPI
~7 min · Free to read
The CPI is the most-cited inflation measure, but it has well-known biases that cause it to overstate the true cost of living. Understanding these biases matters because billions of dollars in government payments, tax brackets, and central-bank decisions are tied to the CPI number.
There are five main biases:
- Substitution bias — when prices rise, consumers switch to cheaper alternatives, but the fixed basket ignores this.
- New-goods bias — revolutionary products (smartphones, streaming) aren’t in the basket until the next update.
- Quality-change bias — if a laptop costs the same but is twice as fast, the effective price fell, but CPI doesn’t capture that.
- Outlet substitution bias — consumers shift to discount retailers or online shopping; CPI may miss the lower prices.
- Shrinkflation — the price stays the same but the package shrinks (e.g., 500 ml ice cream becomes 450 ml). The per-unit price rose, but CPI records no change.
Trap · Warning
Why CPI Bias Matters
CPI overstatement has real-world consequences:
- Pensions & Social Security are indexed to CPI — overstatement means governments overpay, straining budgets.
- Tax brackets adjusted by CPI — overstatement means bracket creep is overcorrected, reducing tax revenue.
- Monetary policy — if the central bank targets 2% inflation but CPI overstates by 0.5%, true inflation might only be 1.5%, leading to overly tight policy.
The ideal cost-of-living index is always less than or equal to the Laspeyres CPI because consumers can substitute toward cheaper goods
Different countries try to address these biases in different ways. The US publishes three main indexes: CPI-U (the headline number for urban consumers), Chained CPI (C-CPI-U, which partially corrects for substitution bias by updating the basket more frequently), and the PCE Price Index (preferred by the Fed, uses current-period weights and covers a broader spending base). In Europe, the HICP (Harmonised Index of Consumer Prices) is the standard — it controversially excludes owner-occupied housing costs, which matters a lot in countries with high homeownership rates.
Check yourself · no marks
A bag of chips used to be 200g for 3 dollars. Now it’s 170g for 3 dollars. The CPI records no price change. Which bias is this?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
In 2020, consumers bought 8 units of Good A at 5 dollars and 12 units of Good B at 3 dollars. By 2024, Good A costs 7 dollars and Good B costs 3.50 dollars. However, consumers actually shifted to buying 5 units of A and 15 units of B. Calculate the Laspeyres CPI and explain why it overstates the true cost of living.
Practice · 1 / 4
Which CPI bias arises because the fixed basket doesn’t account for consumers switching to cheaper substitutes when prices rise?
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