Measurement Biases in Consumer Price Indexes

Abstract

Summary The Consumer Price Index (CPI) measures the cost of purchasing a fixed basket of goods at a fixed sample of outlets over time, and can be thought of as a practical approximation to a “true” cost‐of‐living index, and a measure of general inflation for the economy. In more recent times, concerns over the possibility that the U.S. CPI overstates the rate of inflation have grown. Annual changes in the CPI are used to adjust social security benefits, and wage contracts are often indexed to CPI changes. To the extent that the CPI overstates the rate of inflation individuals are being compensated for changes in the cost‐of‐living that have not occurred–with enormous implications for government fiscal budgets. This paper presents an up‐to‐date survey of the principal sources of measurement error or bias in the CPI. A number of sources of bias are examined, including the commodity substitution bias, the outlet substitution bias, and the elementary index bias. Traditional bilateral index number theory assumes that the number of goods remains constant over the pricing period and furthermore, that the goods are of unchanging quality. Changes in either of these give rise to two further biases: the new goods bias and the quality bias.

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