Explain the concept of substitution bias in the CPI.

The concept of substitution bias in the Consumer Price Index (CPI) refers to the potential distortion in measuring inflation due to the fixed basket of goods and services used to calculate the index. The CPI is designed to measure changes in the cost of living over time by tracking the prices of a fixed set of goods and services that represent the average consumer's spending patterns.

However, substitution bias arises because the CPI assumes that consumers do not change their consumption patterns in response to changes in relative prices. In reality, when the price of a particular good or service increases, consumers tend to substitute it with a cheaper alternative. For example, if the price of beef rises significantly, consumers may switch to buying chicken instead.

This substitution behavior is not fully captured in the CPI, leading to an overestimation of the inflation rate. The fixed basket of goods and services used in the CPI calculation does not account for changes in consumer preferences and their ability to substitute one good for another. As a result, the CPI may not accurately reflect the true cost of living for consumers.

To address this issue, the Bureau of Labor Statistics (BLS) introduced the concept of "chained CPI" in 2002. Chained CPI takes into account the substitution effect by allowing the basket of goods and services to change over time as consumers adjust their consumption patterns. This method provides a more accurate measure of inflation by reflecting the actual choices made by consumers in response to price changes.

In conclusion, substitution bias in the CPI refers to the distortion in measuring inflation caused by the fixed basket of goods and services, which does not account for consumers' ability to substitute one good for another. This bias can lead to an overestimation of the inflation rate, but it can be mitigated by using alternative measures such as the chained CPI.