A couple more cold days for Florida may lead to more problems in measuring the cost of living.
Article: http://www.nytimes.com/aponline/2010/01/07/business/AP-US-Commodities-Review.html?scp=3&sq=oranges%20freeze&st=cse
If a series of major frosts were to destroy the nation's orange crop, the quantity of oranges produced would fall to zero. Following this, consumers can expect to see the price of the oranges that remain to sky rocket. Furthermore the oranges lost from the frost, are no longer apart of GDP, and the increase in the price will not be accounted for by the GDP deflator. But because CPI is computed with a fixed basket of goods, that includes oranges, the increase in prices would lead to a substantial rise.
One of the more subtle differences between CPI and the GDP deflator results from the way the two measures aggregate the plethora of prices in the economy. The CPI is considered to be a Laspeyres index, in that it's computed using a fixed basket of goods, whereas the GDP deflator , a Paasche index, allows the basket of goods to change overtime.
In the example of the destroyed orange crop, CPI would most likely overstate the impact of the increase in orange prices on consumers, because it ignores the consumer's ability to substitute for goods whose relative prices have fallen (Substitution Bias). In contrast, because the GDP deflator is a Paasche index, it understates the impact on consumers as it shows no rise in prices, yet the higher price of oranges would surely make the consumers worse off. Despite these incongruities, the difference between the GDP deflator and the CPI is not usually that large and both seem to tell the same story about how quickly prices are rising. At the same time however, some economist have suggested revising laws to reduce the degree of indexation. In the work by Matthew Shapiro and David Wilcox, "Mismeasurement in the Consumer Price Index: An Evaluation" it concludes that CPI does overestimate the cost of living, and their evidence suggests that the bias is centered on 1.0% point per year. Overall CPI is a very closely watched measure of inflation, given the weight it has on policy makers decisions a mismeasurement has potentially profound impacts on both fiscal and monetary policy. At bottom, in cold days like these, it's time we give measurement problems a closer look.
I am not so sure that CPI would overestimate the impact of the increase in orange prices due to the fact that it ignores the consumers ability to substitute for goods whose relative prices have fallen because most of the goods that any given consumer would substitute for an orange would most likely be devastated by the same weather seen in recent weeks in Florida. Weather systems are beginning to change and I believe that this is a trend that will be more common in the future.
ReplyDeleteI was unaware that substituite goods for orange juice, such as "Tang" and other fruit drink mixes grew on trees. Of course there will be some lag on consumer prefrence but the switch from a now high priced fresh squeezed oj, to frozen oj from concentrate, seems much more plausibl given the current nature of the common household budget.
ReplyDeleteCPI may overestimate inflation because of substitute bias. In 1995, the Senate Finance Committee appointed a panel of five noted economists to study the magnitude of the measurement error in the CPI. The panel concluded that the CPI was biased upward by 0.8 to 1.6 percentage points per year, with their best estimate being 1.1 percentage points. The report led to some changes in the way the CPI is calculated, so the bias is now thought to be slightly under 1 percentage point. The CPI still overstates inflation, but not by that much as it once did.
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