Question

Samantha goes to the grocery store to make her monthly purchase of ginger ale. As she enters the soft drink section, she notices that the price of ginger ale has been increased 15 percent, so she decides to buy some peppermint tea instead. Which of the following problems in the construction of the CPI is this situation most relevant to?
a) substitution bias.
b) introduction of new goods.
c) unmeasured quality change.
d) income effect.

Answer 1

Answer:

The correct answer is substitution bias.

Explanation:

Samantha goes to the grocery store to purchase ginger ale.  

She notices that the price of ginger ale has been increased 15 percent, so she decides to buy some peppermint tea instead.

But in the calculation of CPI, this increase in the price will be included and the substitution of cheaper goods for the expensive one. The value of CPI will increase and inflation will be overestimated.  

Though consumer spending is not increasing as she is purchasing the cheaper goods instead of a more expensive one, the CPI will indicate higher spending.  

This problem is referred to as substitution bias, as substitution of goods is not included in the calculation of CPI.