Consumer Price index(CPI) is the average price of product and services purchase by the consumers. Where The GDP price index measure the rate inflation of all products and services on the other hand CPI indicates the change in consumer prices for the defined time period, increase in index shows the level of inflation at consumer end. There are many different CPI is calculated by region,types of products, types of consumer etc. The most common CPI is CPI-U, which is CPI for urban area because maximum percentage of products are purchased in urban areas. CPI is calculated for the given basket of goods to determine the change in index on monthly or annually.
Formula to Calculate CPI
CPI = Basket in any given year/ Price of the same Market * 100
CPI = $300/$200 * 100 = 150
Consumer price index show the change in consume products in a given period of time.
Deflator of other economic series
The CPI and its components are used to adjust other economic series for price change and to translate these series into inflation-free dollars.
Adjusting income payments and Taxes
Over 2 million workers are covered by collective bargaining agreements which tie wages to the CPI. The index affects the income of almost 80 million people as a result of statutory action: 47.8 million Social Security beneficiaries, about 4.1 million military and Federal Civil Service retirees and survivors, and about 22.4 million food stamp recipients. Changes in the CPI also affect the cost of lunches for the 26.7 million children who eat lunch at school. Some private firms and individuals use the CPI to keep rents, royalties, alimony payments and child support payments in line with changing prices. Since 1985, the CPI has been used to adjust the Federal income tax structure to prevent inflation-induced increases in taxes.
When there in increase in prices of consumer good people consumer less and move towards buying other low price alternatives is called substitution bias.
Quality Change Bias
Quality of products is improved with the advancements of production methods, life of the product is more then the past. For example, If person bought an expensive dress and use it for 3 years cost per day is very low as compared to the dress he bought at lower prices( low quality) and used it for one year. There is no parameter in CPI to indicate the improvement in quality with the passage of time.
Outlet substitution bias
People used to buy product from normal shops, shopkeepers have to pay less rent for the shop but today people are shopping at wholesale shops, convenience shops,super markets etc. The shopkeepers have to pay high fixed and variable cost for the shops which also impact the prices of products. Consumers can easily purchase products in less time without any problem, CPI not includes the following benefits result in outlet substitution bias.
New product bias
Thousands of products are introduced in the consumer market each year but are not included in the CPI is called new product bias. For example, The price of cell phone decline and quality is improved as compared to 1990s and bring improvement to people lives but still the prices of cell phones are not included in the consumer price Index.