Introduction
Almost all nations of the world that are business oriented prepare annual financial statements that give an indication of how the entire economy is performing. The major financial document prepared is the budget that shows how the funding and income of the nation have been used throughout the financial year.
All this information is relied on by the population of the country and to the country’s top management for use in decision and policy making. From the prepared statements the country’s financial analysts and auditors are in a position to identify any deviations from the normal hence are in a position to make decisions (Rossiter 1).
One of the main statistical measures that any country looks for is the rate and changes in inflation. A country’s economy is majorly affected by even the slightest change in the rate in inflation. To gauge the rate of inflation, financial analysts use the Inflation gauge also referred to as the consumer price index.
Consumer price Index in the Past
The inflation gauge a.k.a consumer price index was developed in the year 1913 by the Bureau of Labor Statistics. It was complied to be in the base of 100 such that a Consumer Price Index of 145 indicates 45% inflation since the year 1982. This therefore indicated that the prices of products change with time thus the past can predict the future cost of the same product depending on the rate of inflation.
The consumer price index was then calculated using a chart or table by either backdating or forecasting. Several charts are available which include; Annual inflation, Inflation by decades and the united inflation. All these charts are provided by the Bureau of Labor Statistics.
An Inflation calculator is also available that calculates the inflation from one month to another or one year to another. Before the indices were given to one decimal place but as from the year 2007 the indices were now given to three decimal places. This helps increase the efficiency and stringency.
The definition of Consumer Price Index
Consumer Price Index is a statistical measure that gives the average weights of prices of different consumer goods. Its calculation is by taking the changes in price of the given commodity in the market and getting their average hence their weights.
The consumer price index is used to indicate any instances of inflation or deflation since any rise or fall in the inflation rates is reflected on the consumer price index. In case of an increase in the consumer price index in the short run this depicts instances of inflation while a decrease of the consumer price index in the short run denotes instances of deflation.
The consumer price index is published monthly unlike other statistical measures because of its sensitivity. However, the consumer price index may be used to compare two financial periods or years. Some of the products and services that are mostly monitored using the Consumer Price Index include; food, transport, water, electricity just to mention but a few (Bacal-4).
These examples clearly show that the basic commodities and services are those that are mostly monitored using the Consumer Price Index. This is because of their necessity in the lives of many people in the population of most nations. It is because of this reason that the CPI is also known as the Cost of Living Index. The consumer price index is unit less and only expressed as a percentage.
Statistically, the consumer price index may be divided into two categories according to the population make up. The first category is the consumer price index for the clerical workers and people living in towns but earning wages that is (CPI-W). The second category is for all the consumers in the urban area that is (C-CPI-U).
Biases of the Consumer Price Index
Despite its use in statistics the consumer price index was found to be subjected to a number of measurement biases. Before the Consumer Price Index was considered to be the inflation rate that captures how the prices of commodities increases.
However, research by Michael Boskin showed that the methodology of Consumer Price Index was wrong hence proving the biases. Michael Boskin is an Economics Professor at Stanford University. He is world-class economist with a good reputation of being a trusted advisor to many presidents and the central banks of most nations.
He served as the Chairman of the Congressional Advisory Commission referred to as the Boskin Commission which introduced changes in the computation of the Consumer Price Index. The consumer price index at that time was believed to be reporting a lower inflation rate than the actual. In his research on the Consumer Price Index; he found a number of problems with the methodology.
In the first place he found out that the consumer price index assumes changes in factors like tax, the quality of water and air, the levels of crime in the country, security, health care and the quality of education (Mcmahon-1). All of these are very important and should be considered if accurate results are to be obtained.
The consumer price index also ignores the kind of life experienced by people living in the rural areas of the country. This is because their kind of life differs completely with that of people living in town centres. Also families that are inclusive of children have a different lifestyle from those without children as their pattern of purchasing products is different.
All these factors need to be put in place and applied in formulation so as to get reliable results from the computation. The problem in measurement of the Consumer Price Index is broadly divided into two groups, which are the sampling errors and the non-sampling errors.
Sampling Errors
The sampling errors are brought about by the data collected in households and cities of the nation so as to compute the consumer price index. The error comes in since only a representative sample of the whole population is taken for computation (David-23). This may not accurately represent the entire population hence leading to biased conclusions.
The types of surveys used include the Consumer Expenditure Survey (CES) which collects data on the income and expenditures of households and the Point of Purchase Survey (POPS) which determines the purchasing outlets.
Non-Sampling Errors
The non- sampling errors arise from the computation of the consumer price index such that the final result reports the wrong inflation or deflation rate. These include;
Formula bias
The formula bias occurs when the current expenditure is divided by the current average price of the commodity so as to get the initial quantities of the commodities in the market. The problem arises where the commodity is sold at the first price it was allocated since this will mean an overstatement of the consumer price index. This is because the prices of commodities are assumed to advance in subsequent months.
Quality Change bias
The quality change bias occurs when the quality of a product or service improves as well as the price of the same commodity (Wolff-96). For example if the quality of a service increases by 20% while its price increases by 25%, an adjustment should be made in the computation to cater for both changes. Lack of adjustment leads to quality underestimation hence a higher rate of the Consumer Price Index.
Substitution bias
Substitution bias occurs where price changes of one commodity make the consumers substitute it for another. For example if the price of tea increases, consumers may prefer to consume coffee instead.
This substitution will not be depicted in computation of the consumer price index hence giving biased results. The substitution bias is divided into two whereby we have lower level substitution which occurs between products of the same genre like white and red grapes. The higher level substitution occurs between products of different genres like bananas and oranges.
Time of the month bias
This comes about as most sales that occur during the weekends and public holidays are not accounted for hence not reflected in the computation of the consumer price index. The resulting consumer price index is not representative and thus giving a biased consumer price index on the higher side.
New product bias
According to the product lifecycle where we have the introduction, development, maturation and decline stages the sales and prices of a product are inversely proportional. The introduced products in the market are not included in the computation of the consumer price index hence it is biased upwards. The delay in the inclusion of the new products into the market basket is what brings about the problem.
New Outlet bias
Some new outlets that are opened tend to attract customers by offering them lower prices of commodities or services. This therefore gives the consumers an opportunity to purchase the same products at lower prices. The current computation of the consumer price index does not take into consideration the price changes hence giving the wrong value at that point in time.
Revised methodology
To overcome the problem of formula bias the Bureau of Labor Statistics created a method known as “seasoning” that adjusted the bias. The Bureau of Labor Statistics has also developed methods that incorporate the new products that come into the market basket since the time it takes to revise the market baskets is very long (Brookster-1).
Once the all the biases were analysed a report was published that put into consideration all the above biases and named the Boskin Report. The report made recommendations to adjust the consumer price index of 1.1% downwards. The adjustments were made according to the source of bias and based on the measured cost of living as shown below.
Estimates of the bias in the Consumer Price Index
Findings
The formation of the Boskin Commission was important as the data obtained from the computation of the Consumer Price Index is further used to calculate other measures such as the annual payment changes in social security as well as retirement and compensation funds. This indicates that overstatement or understatement of the rate of inflation leads to making of wrong polices and decisions of an organisation or nation.
In circumstances where the Consumer Price Index is overstated there are numerous aftermaths that are not desirable. For example the taxation rates may be raised up which in turn may lead to collection of less tax revenue by the government (Heather-1). Any differences hence lead to high national debt and a wrong depiction of the state’s economy.
Conclusion
It can therefore be concluded that the work that was done by the Boskin Commission under the leadership of Michael J. Boskin of Stanford University was commendable. The report given has helped iron out any discrepancies that may arise during computation of the consumer price index.
It can also be recommended that any financial analyst that does works out the consumer price index should put into consideration the biases so as to give data that can be relied upon (Smith-1). They are also advised to follow the table on estimation of biases based on the measure of the cost of living for downward adjustment of the consumer price index.
Works Cited
Bacal, Thomas. “The Latest Release from the consumer price index.” 2010. Web.
Brookster, Edson. “Consumer Price Index.” 2010. Web.
David, Merlin. “Statistics: Concepts and Controversies.” 1997. Web.
Heather, Faber. “Inflation.” 2010. Web.
McMahon, Lauryl. “Historical Consumer Price Index.” 2003. Web.
Rossiter, John. “Measurement Bias in the Canadian Consumer Price Index.” 2010. Web.
Smith, Michael. “Measuring the Changing Value of Money.” 1997. Web.
Wolff, Eathen. “What has happened to the quality of life in the advanced industrialised nations?” 1997. Web.