Please explain how B is correct when quality is improved and price is same how CPI is upward bias.
Secondly, if it is upward bias than what adjustment it is talking about.. that even if we price is increased, why still it will be upward biased.??
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But what about the adjustment they are talking about in answer?
Everything i will discuss from scratch
As you know inflation is measure as a percentage change i price index.So a price index represent the average price of basket of goods & services.
Base year is the period with which we compare the prices for the current period.So laspeyres index is the most common type of index it is created by holding the consumption basket constant.
Ex:- The consumption basket last year would be 10 litres of milk and 5 kg of apple if it changes this year to 12 litres of milk and 6 kg of apple, then when calculating the index we take the initial quantity of the consumption basket and not the recent one
Laspeyres index is a base weighted index which means the price increase are weighted using the quantities of the base year and you know the formula of laspeyres index
Many countries use laspeyres index when calculating inflation
All these strategy few biases ( all the biases cause the index to be overstated)
Substitution bias:- As price of a good increase people Substitutes the good with a cheaper good
Ex:- Assume you have a consumption basket comprising 5 units of fruits and 5 units of vegetables.If fruits become expensive then people will change their consumption basket of 2 units of fruits and 8 units of vegetables.But the index computes prices based on a fixed consumption basket of 5 units of fruits and 5 units of vegetables.Index weighted on these quantities or an inflation rate based on this price index will be biased upward or overstated
Quality bias:- Quality of goods and services improves over time.Let understand this concept with the help of cars
Even though car has become expensive, the improvement in quality is more than the price which is not reflected in the index calculation
New product bias:- New products entering the market are not included in the consumption basket as the basket is fixed
So we have paasche index
Paasche index:- It allows for the consumption basket to change.It uses the consumption basket in the current period.It measures the change in the price of consumption basket weighted by using the quantities in the current period