Substitution bias and the construction of a spatial cost of living index

Abstract

We estimate the spatial substitution bias based on the difference between a price index (PI) and the true cost of living (COL). This bias is computed at three geographical scales, using several fixed baskets and across different expenditures quartiles. Our results show a significant substitution bias for small geographical units. The choice of the base basket is also relevant for the bias estimation. Finally, the spatial substitution bias is larger for upper side of the expenditure distribution due to the heterogeneity in the consumption basket. This exercise shows that the spatial dimension affects the construction of a price index and that the approach of fixed baskets should be carefully considered in the estimation of spatial price differentials. JEL classification: R21, C36

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