Since late 2006, OPEC has successfully raised world oil prices significantly. These price increases have caused governments and firms to explore alternative sources of energy, for example bio-fuels. Consumers too have started switching toward hybrid automobiles and toward automobiles that use bio-fuels, both of which are cheaper to operate than gasoline engines. Which problems in the construction of the CPI does this situation represent?

Question

Quizplus · Accepted Answer

The situation described represents both substitution bias and new-product bias in the construction of the CPI. Substitution bias occurs when the CPI does not account for consumers switching to cheaper alternatives, such as bio-fuels, which results in an overestimate of the true inflation rate. New-product bias arises when the CPI does not account for the introduction of new, cheaper products, such as hybrid automobiles, which can also lead to an overestimate of inflation if the CPI does not adjust for their presence.

Since Late 2006, OPEC Has Successfully Raised World Oil Prices