Substitution bias describes a bias in economics index numbers arising from tendency to purchase inexpensive substitutes for expensive items when prices change.
Substitution bias occurs when two or more items experience a change of price relative to each other. Consumers will consume more of the now comparatively inexpensive good and less of the now relatively more expensive good. This influences the CPI basket. For example, a selected good is bought by consumers and it is therefore included in the CPI basket, but when an increase in price of that selected good occurs customers may buy a cheaper substitute, while the CPI basket does not change. If product A is purchased by most consumers, and product B has a sale making it cheaper, consumers will naturally buy what is cheaper.
Because of its effect on consumption, substitution bias can cause inflation to be over-estimated. Data collected for a price index, if from an earlier period, may poorly correspond to the prices and consumer-expenditure-shares going to goods whose prices later changed. To reduce this problem, several steps can be taken by makers of price indexes:
- Collect price data and expenditure data frequently to capture recent changes
- Adopt superlative index formulas for price indexes, usually Tornqvist indexes or Fisher indexes]]
- Use hedonic regression methods to capture quality changes for specific product types and the implicit prices of their attributes; see hedonic index
- National Research Council. 2002. At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes. Washington, DC: The National Academies Press. https://doi.org/10.17226/10131.
- The Advisory Commission To Study The Consumer Price Index (aka the Boskin Commission). 1996. Toward A More Accurate Measure Of The Cost Of Living (html), also released as Final Report of the Advisory Commission to Study the Consumer Price Index (pdf).