Question

Suppose that households have significantly reduced their consumption of beef in response to a rise in beef prices, and substituted it with a cheaper good, chicken. However, the CPI basket (i.e., consumption weights) was not adjusted accordingly. As the result, CPI inflation estimate is likely to:________.

Answer 1

Answer: Substitution bias:

Explanation:

Substitution bias explains a possible bias in economic index numbers if they do not incorporate data on consumer expenditures changing from products with a relatively high cost to a product with a cheaper price as the prices changes.

Substitution bias happens or can occurs when prices for products change relative to one another product. Consider how consumer expenditures are reflected in a consumer price index. Consumers will tend to buy more of the good whose price declined, and less of the now relatively more expensive good.