Question

Describe the inherent measurement problems with price indexes that employ a fixed basket of goods. Include an example of each type of problem.

Answer 1

There are inherent measurement problems with price indexes that employ a fixed basket of goods. With a fixed basket of goods, even after incorporating and evaluating the change in the price basket, it doesn’t acknowledge the change in prices of all products.

For example : If a fixed price basket does not include a product like noodles, the change in price will not impact the CPI.

Although it is a very small example, but it helps in understanding the concept.

Further, it also ignores the effect of substitution of products. For example, if the basket includes wheat in it and not rice, and a change in price has lead to a substitution of wheat with rice, then the quantity demanded for wheat would fall down and rice would rise. This might in future bring down the CPI but is not fully representative of the current market scenario

Lastly, innovations or novelty products are not a part of the CPI but are important in the economy. Until these become staple/regular purchases by the consumers, they are not added in the CPI calculation which might not be a good indicator in that case.