All price indexes contain certain distortions or biases that reduce their effectiveness as measures of inflation. Describe these distortions and how they affect price indexes

Answer 1

One distortion is caused by changes in product quality. For example, if the price of tires increases from $25 in 1970 to $80 in 1999, it looks like a $55 increase in the price of tires. But if the quality of the tires has changed over these years, then the dollar value people receive from the tires in 1999 may be as high as the dollar value they received from the 1970 tires. In other words, in real quality terms, prices haven't increased at all. Therefore, the true extent of inflation tends to be overstated in price indexes.
Another bias arises from the different kinds of goods that make up the basket. For example, if the base year is 1970 and remains at 1970 in the year 2000 . then the goods that we typically buy in 2000 . such as computers, are not represented in the basket. The basket becomes less reliable as a measure of changing prices. We must keep updating the base year to overcome this problem.