Inflation is the rate at which prices are increasing in an economy, which is often measured using the consumer price index. The consumer price index, or CPI, measures inflation by comparing the prices of a certain basket of common consumer goods over time. For example, the CPI might include the cost of basic foodstuffs, gasoline, electricity and clothing. While the CPI is one of the most common indicators of inflation, it has several notable disadvantages as a measure of inflation and the overall cost of living.
How the CPI Works
The CPI tracks the changes in prices of certain goods over time, where the total cost of the entire basket is set to 100 in a certain base year. The price of the basket in subsequent years can then be easily compared to the base year. For example, if the CPI in the year following the base year is 101, prices rose 1 percent over the last year.
Changing Preferences
One potential source of inaccuracy in using the CPI as a measure of the cost of living is that consumer preferences change over time according to the costs of products that are available. If a certain product goes up in price over time more than others, consumers will tend to buy less of the more expensive product and more of less expensive alternatives. In other words, the CPI may overstate the increase in the cost of living by failing to take account of changing consumer preferences. In addition, some consumers shop at discount stores and outlet stores, which may offer prices that are significantly lower than those used in the CPI calculation. This can also contribute to the CPI overstating the increase in the cost of living.
Quality of Goods
Another disadvantage of using CPI as a measure of the cost of living is that it may fail to take account of the increase in the quality of goods over time. A car that you buy today might have better safety features and gas mileage and require fewer repairs than a comparable car 10 years ago, but the CPI does not take account of the impact of increased product quality. Similarly, the quality of medical care that you can receive today is likely higher than what you would have been able to get 30 years ago.
New Products
Another source of potential bias in the CPI is the introduction of new consumer products. When new products are released, they may not be included in the basket of goods used to calculate CPI for many years. New products often fall in price during the beginning of their lives, but if they are not included in the CPI during this period, it will not take account of those falling prices.
