Substitution bias describes a possible bias in economic
index numbers
In Statistics, Economics and Finance, an index is a statistical measure of change in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, an ...
if they do not incorporate data on consumer expenditures switching from relatively more expensive products to cheaper ones as prices changed.
Substitution bias occurs when prices for items change relative to one another. Consider how consumer expenditures are reflected in a
consumer price index. Consumers will tend to buy more of the good whose price declined, and less of the now relatively more expensive good. This change in
consumption
Consumption may refer to:
*Resource consumption
*Tuberculosis, an infectious disease, historically
* Consumption (ecology), receipt of energy by consuming other organisms
* Consumption (economics), the purchasing of newly produced goods for curre ...
may not be reflected in the longstanding
market basket
A market basket or commodity bundle is a fixed list of items, in given proportions. Its most common use is to track the progress of inflation in an economy or specific market. That is, to measure the changes in the value of money over time. A ...
from which a
consumer price index is constructed. If a selected good is bought by consumers and it is therefore included in the CPI basket, but when an increase in price of that selected good occurs customers may buy a cheaper substitute, while the CPI basket may not quickly capture this change. If product A is purchased by most consumers, and similar product B goes on sale making it cheaper, consumers will naturally buy what is cheaper.
Substitution bias can cause
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
rates to be over-estimated. Data collected for a price index, if from an earlier period, may poorly correspond to the prices and consumer-expenditure-shares going to goods whose prices later changed. To reduce this problem, several steps can be taken by makers of price indices:
[The Advisory Commission To Study The Consumer Price Index (aka the ]Boskin Commission
The Boskin Commission, formally called the "Advisory Commission to Study the Consumer Price Index", was appointed by the United States Senate in 1995 to study possible bias in the computation of the Consumer Price Index (CPI), which is used to mea ...
). 1996.
Toward A More Accurate Measure Of The Cost Of Living
(html), also released as
Final Report of the Advisory Commission to Study the Consumer Price Index
(pdf).
* Collect price data and expenditure data frequently to capture recent changes, and incorporate both into the indices quickly
* Adopt
superlative index formulae for price indices, usually
Tornqvist indexes or
Fisher indexes
* Use
hedonic index A hedonic index is any price index which uses information from hedonic regression, which describes how product price could be explained by the product's characteristics. Hedonic price indexes have proved to be very useful when applied to calculate ...
methods to capture attributes of products and their implicit prices; see
hedonic regression
In economics, hedonic regression, also sometimes called hedonic demand theory, is a revealed preference method for estimating demand or value. It decomposes the item being researched into its constituent characteristics, and obtains estimates of ...
and the related index problem of
quality bias
Quality bias in price indices is a kind of mismeasurement if they do not incorporate data on the quality of goods from period to period, as well as their nominal price.
Personal computers are a canonical case. Because of improvements in compute ...
.
References
{{DEFAULTSORT:Substitution bias
Price indices