Suppose that a CPI basket includes avocadoes, pineapples and oranges. Avocadoes become very expensive, and consumers substitute away from avocadoes and buy hummus instead. If the CPI basket does not change to reflect the move away from avocados, the result is:
A)understated inflation.
B)the failure to capture real variables versus nominal variables.
C)substitution bias.
D)quality bias.

Question

Quizplus · Accepted Answer

This scenario represents substitution bias, which occurs when the CPI does not reflect the fact that consumers are substituting towards cheaper alternatives when the price of one item increases. As consumers substitute away from expensive avocadoes towards cheaper hummus, the CPI does not reflect this change and overstates the inflation rate.

Suppose That a CPI Basket Includes Avocadoes, Pineapples and Oranges