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What is the substitution effect in the CPI calculation?

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What is the substitution effect and how it factors into the calculation of the CPI?

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Solution Summary

The 411 word cited solution provides a good explanation of the processes involved in the CPI calculation.

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Initially the CPI was a single index consisting of a group of consumer goods and services that was used to measure the changes in prices for an estimated 87% of the population. The consumer base was presumed to be urban workers while excluding farmers, military and prisons. The changes in CPI were designed to help business, government and individuals understand the effects of inflation. It worked well from post World War II into the 1980s.

The rating became more and more important in economic terms because the rate of change began to be used to adjust other payment amounts such as increases in social security for retirees. The CPI was used to adjust ...

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