So just like most statistics and most concepts in economics, CPI, Consumer Price Index is not perfect. Let's talk about some of the issues that we run into when we use CPI as a measure of inflation. Some of the problems we run into with CPI is that they might overstate inflation. It might overstate inflation for some of these reasons. So we're just going to kind of talk about these, 4 different biases that emerge when we use CPI. And let's go ahead and start here with the substitution bias.
Substitution bias talks about the idea that the same amount is being purchased each month in the CPI. Remember, when we say this is what's in the basket of goods, well, we're going to calculate the same amount of being purchased in each month but what happens if prices change? If the price of something goes up as we've learned with our supply and demand, if those prices are going up, we're probably going to substitute to buy something else instead, right? So if we see the price of apples start to shoot up, people are going to be unlikely to buy as many apples. However, the CPI calculation is going to assume that the same amount of apples are being bought. So what's that going to do? It's going to overstate inflation, right? Because it's showing that people are still buying the same amount of apples at this higher price where instead people were buying, instead of apples, they started buying oranges or some other fruit instead. So as the prices rise for apples, apples go up. As the price of apples goes up, the quantity of apples goes down, right? Just like we saw with the law of demand, the price of apples go up, the quantity of apples demanded will go down. So, people will start substituting to buy other things. So although the problem here with the CPI is that it's going to say that the purchases remain constant, so it's going to overstate the actual price of the basket because it's keeping the basket constant when in fact, people are actually changing what they put into their basket because of these rising prices.
Let's go on to the next one, the quality bias. So what's the quality bias? That over time, the quality of items tends to increase, right? Technology is increasing. The way we produce things is getting better, so we would think that the quality of items is getting better over time. So, what do you think happens when we have higher quality items? Generally, the price goes up when we have higher quality items. When we've got faster computers, faster cell phones, right? The prices start going up. So these quality improvements, they're embedded into the price. However, when we think about CPI, they're just saying, oh, we're buying the same thing. They're thinking that the cell phone that we bought 5 years ago is the same as the cell phone we bought now. However, we're paying for a different thing with the cell phone now, right? We're buying the better technology, the touchscreen technology, the app integration that it has. So these quality improvements, they're embedded into the price. However, when the basket looks at it, it just says, oh, cell phone price was this at this time, cell phone price is much higher now, that must be because of inflation. However, part of that is also going to be because of the quality improvement. So the price may have increased due to quality as well, not just inflation. However, the CPI is just looking at the price change as inflation.
Let's go on to the next one, new product bias. So introduced, it may not be included in the basket and that's exactly what happened in the nineties. Cell phones were not included in CPI until the late nineties. Okay? So millions of cell phones were in use and they were quite expensive when they first came out and then the prices started to drop and then obviously we've started to see increases in cellphone prices again as they've gotten more technologically advanced with apps and touchscreen, all of this like we talked about. But what does tend to happen when a new, technology comes out such as when the DVD player came out or HDTVs, they were really expensive when they came out and they weren't included in the basket, but those prices tend to decrease over time as the technology gets better, production gets a little better of them. We'll see that the price actually starts to decrease a little bit after they're first introduced. However, these price decreases will not reflect in CPI. So we're actually seeing some decreases in prices that are actually beneficial for the customer and which would lower technically the price level. However, since those products are not in the basket, these new products such as when the DVD player came out, it wasn't included well, then that's not going to be included in the CPI calculation. So it's going to overstate inflation again, right? Because it's not taking into account these price decreases.
Finally, we have outlet bias and this is a relatively new one where the way people shop has changed over time. So generally, people shopped in brick and mortar stores, they go to the store, they buy whatever they want. But of course, now, the first thing that happened was people started buying at discount chains. So they'd go to Costco or Sam's Club and they would buy in bulk to save some money. So, if the CPI calculation had you buying toilet paper and they had you buying it at just the grocery store for a higher price, however, people were now going to discount stores and buying, you know, pallet full of toilet paper for a lower price. Well, that would affect the price they're actually paying for these goods, right? So the CPI calculation would be taking this grocery store price instead of this discount price that people to purchase their home goods and generally get it at a cheaper price. So when they're calculating CPI, if they're using these store prices rather than the actual prices people are paying that might be a little lower, well, it's again going to inflate, overstate inflation. Right? It's going to think that people are paying more than they actually are.
These are some of the problems that come up with CPI. Again, when we study CPI, these could come up in some, you know, random multiple choice questions. But the main thing you want to know is how to calculate CPI. It's still a very important calculation for this test and how we use it to calculate inflation as well. Cool? Alright. That's about it for this video. Let's go ahead and move on to the next one.
