Chapter 15, Problem 2CYU

To determine

The question requires us to explain the impact of using a 10-year-old market basket of price changes on the given events.

Explanation of Solution

The first event is overestimating the value of the price index while the second event is underestimating the value of the price index if one uses 10-year old basket for the estimation of a price index.

Explanation:

1. Suppose, 10 years back, consumers own 3 cars at $x per car rate, and the market basket which consists of 10 cars has a value let's say $y. Due to the rise in the price of cars by a larger sum, consumers substitute cars with cheaper goods. The cost of a basket in the current year rises from $y to $1.6y (let) even when consumers are consuming fewer cars. So, the given event causes the overestimation of the price index if the estimation is based on a 10-year-old market basket.
2. Before 10 years, the consumption of broadband was almost zero or negligible. So, the share of tablet PCs in a market basket was zero, but now consumption of tablet PCs is higher, and their price is falling. If one considers a 10-year-old basket to estimate the current price index, the estimation will be understated because the new price index doesn't include the consumption of tablet PCs.