What is the commodity substitution bias? What effect does it have on the CPI?

Question

What will be an ideal response?

Answer 1

The commodity substitution bias refers to the fact that people switch (substitute) away from goods and services that have risen in price and buy more goods and services that have not risen as much in price. Thus if the price of Coke rises 20 percent while Pepsi's price does not change, many people will substitute Pepsi for Coke. The commodity substitution bias in the CPI occurs because the CPI uses a fixed market basket of goods and services. So, if the market basket contains, say, 10 bottles of Coke and 8 bottles of Pepsi, the market basket will not change even though people change their buying patterns in favor of Pepsi and away from Coke. The change in people's buying patterns offsets, at least to a degree, the effect of higher prices. In the Coke/Pepsi case, by purchasing more Pepsi and less Coke, people have insulated themselves from part of the effect of the higher price of Coke. However the CPI does not take this change into account and so the CPI reflects the full effect of the higher price of Coke, thereby overstating the actual inflation that people experience.