What is substitution bias in the context of the Consumer Price Index (CPI)?

Substitution bias refers to the tendency of the Consumer Price Index (CPI) to overestimate inflation due to the way it is calculated. The CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The market basket is based on fixed quantities of goods and services, which means it does not account for changes in consumer behavior when prices change.

When the price of a specific good rises significantly, consumers may substitute that good with a less expensive alternative. For example, if the price of beef increases, consumers might buy more chicken or pork instead. However, the CPI does not reflect this behavioral adjustment because it assumes consumers continue to purchase the same fixed quantities of goods regardless of price changes. Consequently, this leads to an overestimation of the cost of living adjustments, which is the essence of substitution bias. Recognizing this bias helps economists understand the limitations of CPI as an economic indicator.