The following three points highlight the top three reasons for overestimation of True Inflation by CPI. The reasons are: 1. Quality adjustment bias 2. Substitution bias 3. Introduction of new products.
Reason # 1. Quality Adjustment Bias:
Government statisticians often face difficulties in measuring changes in the quality of goods.
For example, if the design of an air-conditioner is so improved that it can put in 10% more cold air without an increased use of electricity, then 10% rise in the price of air-conditioner should not be treated as inflation.
No doubt consumers are paying 10% more.
But they are also enjoying 10% more cooling capacity. However, government statisticians often fail to take account of the improved quality of the air-conditioner and simply note its 10% increase in price, the price rise will be wrongly taken as inflation.
For some products, it is very difficult to measure quality (as in the case of services). For example, we do not know to what extent (in percentage terms) the quality of banking service has improved due to the availability of 24-hour cash machines.
To the extent that the CPI fails to account for quality improvements in the goods and services people use, inflation will be overestimated. Such overestimation is known as the quality adjustment bias.
Reason # 2. Substitution Bias:
There is another problem with CPI as a true measure of inflation. This problem arises when consumers show substitution bias. Suppose that consumers like mutton and fish almost equally and, in the base year, consume equal amounts of each. But for some reason the price of mutton rises sharply, inducing consumers to eat only fish. Thus the cost of living is not much affected by the rise in price of mutton.
However, the CPI — which measures the causes of buying the base-year basket of goods and services — will record a significant increase when the price of mutton rises sharply. Thus the rise in CPI overestimates the true increase in the general price level. This problem arises because the CPI is based on the assumption that consumers purchase a fixed basket of goods over time.
It fails to take note of the fact that consumers often substitute .cheaper goods or services for more expensive ones. This source of overestimation of true inflation is known as the substitution bias.
Reason # 3. Introduction of New Products:
If new products with high prices are supplied by firms the CPI will go up. This is another reason why the CPI over estimates inflation.
If CPI overestimates true inflation, then increases in real income of atypical family (which is the true indicator of its purchasing power) are correspondingly underestimated. The wages of industrial workers are often linked with cost of living indices, as measured by the CPI, so as to protect living standards of the workers in the organised sector.
If CPI overestimates inflation, then workers will receive more wages than are necessary to compensate them for increases in the cost of living. Their real income goes up, but they think that it remains the same because nominal wage rises as fast as the price level shoots up.