Describe the three problems that make the consumer price index an imperfect measure of the cost of living. If the price of a Navy submarine rises, is the consumer price index or the GDP deflator affected more? Why?
The correct answer and explanation is:
The Consumer Price Index (CPI) is a widely used measure of the cost of living, but it is not perfect. Three key problems that make the CPI an imperfect measure are:
1. Substitution Bias
The CPI assumes that consumers purchase the same basket of goods and services over time, regardless of changes in relative prices. In reality, consumers tend to substitute cheaper alternatives when prices of certain goods rise. For example, if the price of beef increases significantly, consumers might switch to chicken. The CPI fails to fully capture this substitution, leading to an overestimation of the cost of living.
2. Introduction of New Goods
The CPI is slow to incorporate new goods and services into the market basket. When new products become available, they often provide greater utility and improve the standard of living. For example, smartphones revolutionized communication and productivity, but the CPI does not immediately account for their benefits or price changes. This delay can result in an incomplete reflection of actual consumption patterns.
3. Unmeasured Quality Changes
The CPI struggles to account for changes in the quality of goods and services over time. For instance, a car or smartphone today may be significantly better than one sold a decade ago, even if the price is similar. If quality improves but prices remain stable or rise modestly, the CPI may overstate inflation because it does not fully capture the increased value consumers derive from higher-quality products.
CPI vs. GDP Deflator for a Navy Submarine
If the price of a Navy submarine rises, the GDP deflator is affected more than the CPI. This is because the CPI measures the cost of goods and services purchased by households, and submarines are not consumer goods. Instead, they fall under government purchases, which are included in the GDP deflator. The GDP deflator captures price changes across all final goods and services in the economy, making it more sensitive to price changes in items like submarines that are not part of typical consumer spending.