The market basket, especially when used in fixed measures like the Consumer Price Index (CPI), is considered biased primarily due to substitution bias. This bias arises from the assumption that consumers do not alter their purchasing habits even when the relative prices of goods and services change, which contradicts fundamental economic theory.
Understanding Substitution Bias
A fixed market basket operates on the premise that consumers continue to buy the same quantity of specific goods and services regardless of price fluctuations. However, in reality, consumer behavior is far more dynamic. When the price of one item rises significantly compared to an alternative, consumers often substitute the more expensive item for a cheaper, similar good.
Consider the following:
- If the price of one popular fast-food burger, for instance, increases sharply, consumers are likely to switch to another brand's comparable burger if its price remains stable or is lower.
- A fixed market basket measure fails to account for this typical consumer response. It continues to include the more expensive item in the basket at its higher price, even though consumers might no longer be purchasing it with the same frequency.
Impact of the Bias
This rigid assumption leads to an overestimation of the true cost of living and, consequently, an overstatement of inflation. Because the basket doesn't reflect consumers' ability to adapt their consumption patterns by choosing less expensive substitutes, it paints a picture of higher expenditures than what people actually incur.
Economic analyses have shown the significance of this phenomenon:
- Substitution bias can account for a substantial portion of the total bias in market basket measurements.
- For instance, it has been estimated to contribute almost 40 percent, or 0.4 percentage points, to the overall bias observed in consumer price indices.
In essence, the bias stems from the fixed nature of the basket, which does not evolve with consumer choices driven by changing relative prices, thereby misrepresenting the real economic burden on households.
