At What Price? Conceptualizing and Measuring Cost-of-Living and Price Indexes (2002) / Chapter Skim
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4 Evolving Market Baskets: Adjusting Indexes to Account for Quality Change
4 Evolving Market Baskets: Adjusting Indexes to Account for Quality Change
Pages 106-154
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From page 106... ...
In about a third of these cases roughly 10 percent of all CPI items each year a quality adjustment is deemed necessary. Moulton and Moses also show that, relative to continuously priced items, replacement items have a disproportionately large effect on the rate of change in the CPI.
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From page 107... ...
The BLS apparently agrees. For instance, when the CPI went from pricing 16-ounce cans of tomato sauce to 14.5-ounce cans, all of the difference in price per ounce was attributed to pure price change (Kokoski et al., 2000:2~.1 1This is not to say that the nonlinear pricing issue is unimportant, particularly for large differences in package sizes.
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From page 108... ...
In the next three sections, we sort though the gradations of quality change that occur along the repackaging spectrum. This discussion includes a brief review of the evidence of CPI bias presented by the Boskin commission (Boskin et al., 1996)
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From page 109... ...
The second half of this chapter assesses the role of hedonic regression techniques in quality adjustment. We offer specific recommendations about the applicability of hedonics for adjusting observed prices or for directly constructing indexes and about approaches to selecting items for quality adjustment.2 COLI AND COGI VIEWS OF THE QUALITY CHANGE PROBLEM The general problem of changing quality can be illustrated by simple example.
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From page 110... ...
Even setting aside the problem that the value attached to changing products may differ widely among consumers, changes in the mix of items sold raise two difficult issues. First, when outgoing items are replaced, COLI calculation requires isolating a pure price component from the observed price difference between the outgoing item and its replacement, which reflects both pure price change and quality change.
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From page 111... ...
Moreover, the quality and taste components of price change are often inexorably intertwined. On the other hand, BLS has to balance on a case-by-case basis the errors that inevitably arise in the adjustment process against the errors that would inevitably arise either from ignoring quality changes or from assuming, as is often done, that all price differences between similar items reflect quality differences.
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From page 112... ...
In the next two sections, we review evidence on quality change bias. First, we briefly examine the Boskin commission report (Boskin et al., 1996)
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From page 113... ...
Reflecting the difficulty of the issue, the Boskin commission report did not advance any formal recommendations about how BLS could improve its measurement of quality changed The Boskin commission suggested perhaps that BLS should be doing more of the things it already does to correct for quality change bias, but seemed to concede that it did not have new ideas for approaching the problem. Summarizing the commission's report, Gordon and Griliches (1997:84)
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From page 114... ...
In this case the question is: "What is the bias, if any, of CPI procedures for handling quality change when quality changes appear on CPI items? " (Triplett, 1997:24~.
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From page 115... ...
Estimating the extent of the first source of bias requires evaluating internal CPI quality adjustment practices. BLS uses a range of quality adjustment approaches when a new item replaces an old one in the sample; the result may add all, some, or none of an observed price change to the index.
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From page 116... ...
With direct comparison, a commodity analyst has determined that it is appropriate to treat the observed price change as pure price change. If any quality change does occur, its effect on the index is not filtered out.
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From page 117... ...
for the direct comparison cases (2.51 percent) is not higher than the quality-adjusted price changes for CPI cases where a direct quality adjustment is made (2.66 percent Table 7~.
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From page 118... ...
The overlap pricing option can be used when both old and new models are available in at least one period. If the new version is introduced in period t and the old version is also available in that period, the price change recorded for the period t and period t + 1 indexes is determined, respectively, by the price relative of the old item for periods t and t - 1 and the price relative of the new item for periods t + 1 and t.
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From page 119... ...
If producers tend to exaggerate the cost of quality improvements, so that reported cost contains an element of pure price change, then the method imposes a downward bias on the CPI (Kokoski, 1993:35~. In such a case, a cost-based adjustment erroneously attributes a portion of the observed price difference to quality change.
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From page 120... ...
work, the Boskin commission arrived at a different conclusion that the bias is likely to be upward stating that the deletion method "bases price change on models that are unchanged in quality and may be further along in the price cycle (Boskin et al., l996~."~2 It is worth noting that nothing precludes the coexistence of both the type of bias that Moulton/ Moses detected and the type that Boskin hypothesized. Research performed by the BLS indicates that producers frequently take the ABLE research showing that price increases tend to coincide with the roll-out of new models is best documented for the apparel and upkeep strata; see Armknecht and Weyback (1989)
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From page 121... ...
The method has been used in the new cars index since 1989 (Moulton and Moses, 1997:327~.13 Assessment of Views on Within-Sample Quality Adjustment As noted above, the Boskin commission report did not seek to identify bias specifically associated with CPI procedures for handling quality change. This was largely a by-product of the commission's decision to estimate new goods and quality change bias together, by CPI category, using independent evidence on quality-adjusted price changes.
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From page 122... ...
HEDONIC REGRESSION METHODS Hedonics currently offers the most promising technique for explicitly adjusting observed prices to account for changing product quality.l4 Hedonic regressions are used to estimate the value of specific bundles of individual characteristics that, when packaged together, form goods. The principle underlying hedonics is that, if consumers face observable relationships between goods' characteristics and their prices, one should be able to use these relationships to disentangle pure price changes from quality changes.
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From page 123... ...
In more realistic cases, there are multiple relevant characteristics, and h is generally not a linear function of their values. In a typical hedonic regression, price, or the logarithm of price, is the dependent variable, and identifiable and quantifiable product characteristics serve as the explanatory variables.l7 In a well-specified equation, coefficients on the explanatory variables reveal the marginal relationship between the product characteristics and price at 16Econometric estimation of hedonic functions dates back at least to the work of Waugh (1928)
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From page 124... ...
and pay the same price. But because individuals value product characteristics differently at the margin, quality adjustments can alter the relevance of an index as a representation of price changes faced by specific groups or individuals.
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From page 125... ...
The method uses a single estimated reference period hedonic function to adjust price quotes for replacement items that appear at sample outlets prior to their integration into normal index calculation. The indirect hedonic method is viewed by BLS as an alternative to deletion or cost-based methods for adjusting prices and to the judgments of commodity analysts for assessing comparability of specifications (as such the merits of hedonic methods should be judged against these alternatives)
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From page 126... ...
This method is indirect because it involves adjusting, post hoc, the observed price difference between the outgoing and the replacement items based on the portion of the price change attributable to quality change. The magnitude of the adjustment is determined by the estimated hedonic function and the differences between the characteristics bundles supplied by the old and new items.
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From page 127... ...
are assumed to differ by the same percentage. If this assumption is correct and the hedonic function is correctly specified, the characteristics variables pick up all price changes driven by quality changes in the menu of varieties on the market and coefficients on the time dummies pick up the residual pure price change.
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From page 128... ...
can be enhanced.23 In contrast to the time dummy approach, the direct characteristics index is as its name denotes constructed from the characteristics coefficients, which are in general allowed to vary over time. The method also offers an advantage over the BLS's deletion or indirect hedonics methods in that it allows for correction of any sample selection bias that may be created because price changes are only sampled from the set of goods or services that remain unchanged from period to period.
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From page 129... ...
(2000:3) characterize the hedonic method, or class of methods, as the "currently preferred method of quality adjustment." The BLS position is that hedonic analysis provides meaningful information for inferring the value consumers place on quality change and that hedonic function estimates based on regression analysis can be reliably used for certain items to make quality adjustments to indexes.
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From page 130... ...
Initially, the technique was used to develop criteria for identifying appropriate comparable replacements for disappearing items. Shortly thereafter, it evolved to its current use as a tool to filter out the quality-driven component of observed price changes associated with item replacements.
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From page 131... ...
It is not surprising that the goods included in the initiative are from the "appliances including consumer electronics" category since it is a product area that has undergone highly visible change. (This category accounted for the largest share of the Boskin commission's estimated 0.6 percent unmeasured quality and new goods bias.)
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From page 132... ...
Nielsen or NPD.26 It is important that BLS continue to examine the implications of using non-uniform data for estimating hedonic regressions and for index construction generally. The CPI Hedonics Model Most of the recent BLS work uses the indirect adjustment method.
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From page 133... ...
Given the difficulty of interpreting coefficients on brand variables, it would be instructive if researchers documented their results with and without brand variables and provided a hypothesis as to what aspects of product value the brand variables are capturing. The BLS hedonics research program has helped reveal that, in practice, applying hedonic methods to price indexes involves confronting very tough issues.
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From page 134... ...
For the subset of substitute items that are deemed noncomparable, BLS then attempts a direct quality adjustment, using hedonics or cost-based calculations or a traditional indirect adjustment method. Other than in its application to personal computers, hedonic adjustments are producing little if any effect on the CPI.31 The effect of increased use of hedonics is limited by: · its narrow application to noncomparable substitute price quotes, · the nature of CPI item substitution itself, and 30U.S.
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From page 135... ...
In some cases, BLS's hedonic models implied price adjustments that would have been larger than the standard (deletion) adjustment actually used; in others the adjustment would have been smaller.32 A more broadly based application of hedonic techniques one that extended beyond routine item replacement cases caused by sample attrition to one that, for example, was also applied to price changes associated with new models appearing as a result of sample rotation would be expected to have a larger effect on the index.
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From page 136... ...
Hedonic applications have most frequently taken the place of the class-mean method. As discussed above, the class-mean approach, like the deletion method, infers quality differences by comparing the observed price change of the replaced and replacement items to the price change of other goods.
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From page 137... ...
version. In other words, the hedonic quality change price adjustment is often smaller than the conventionally used implicit quality adjustment.
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From page 138... ...
One of the benefits of using a hedonic model in evaluating substitutions is that the analyst has an opportunity to review price data and item characteristics with a statistical tool, thus enabling him/her to render judgments based on statistics rather than expert judgment alone. When BLS uses hedonics, comparability of substitute quotes is judged not in terms of an a priori determination about the amount of quality change, but by the extent to which price change is predicted by the regression equation.34 For substitute price quotes, "differences in the specification or characteristics data of the old and new items were identified to see if the parameter estimates in the hedonic model could be utilized to quality adjust the official price change" (Thompson, 34The "standard" comparability decision in forced when a commodity analyst must add to the sample a replacement item that does not match the detailed description of the old one.
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From page 139... ...
VCR price substitutions produced for the published class-mean adjusted index decreased by 3.72 percent; the 83 directly compared price substitutions left over after hedonic adjustments were added decreased by only 1 percent. It is not intuitively obvious why the choice of noncomparable quality adjustment method should have such a large effect on the price change of the subset of comparable substitute quotes.
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From page 140... ...
Also, current BLS rules for replacing disappearing products further minimize quality differences between outgoing and incoming products which, in turn, lessens the importance of which type of quality adjustment is ultimately selected. However, as the Moulton et al.
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From page 141... ...
Recommendation 4-2: BLS should continue to expand its experimental development and testing of hedonic methods and its support of relevant outside research. This research should not be confined to that relating to price adjustment but should also examine the role of hedonics in statistical audits of the other BLS quality adjustment methods and in the review of replacement item selection procedures and comparability decisions.
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From page 142... ...
Despite the early success of hedonics to move quality adjustment in the CPI toward a statistically based approach, considerable judgment by researchers is still required. For instance, early introduction of video memory as an explanatory characteristic in regressions for PCs yielded "implausibly high coefficient values," so the variable was left out of initial specifications.
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From page 143... ...
If the hedonic functions were known in every period, some variant of the direct characteristics method would be the best way to derive price ratios. Sometimes this would reduce to the direct time dummy method, but there is no reason to think this would occur frequently.
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From page 144... ...
Rerunning current models with new data may not be overly burdensome, but respecifying models is highly labor intensive. Given that data collection and model estimation requirements may impose more than a 1-month lag in many cases, it may be necessary to figure out how best to use an estimated surface based on 6-monthold data to compute hedonic functions for the most recent monthly index.
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From page 145... ...
The hedonic results should always be evaluated against BLS's currently used alternatives (generally those associated with implicit quality adjustment techniques) , as opposed to some idealized flawless solution.
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From page 146... ...
Shelter The Boskin commission produced detailed back-of-the-envelope calculations, based on assumptions about rental unit quality and size, to estimate a 0.25 percent annual bias for the shelter cost index. The commission's position that CPI quality adjustments have been inadequate for shelter was deduced from the premise that newer apartments have increased significantly in quality (as reflected by improved amenities, such as central air conditioning)
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From page 147... ...
, is that Gordon measured year-to-year price changes only for the subset of apparel items that remained identical. The methodology links out or deletes the price increases associated with new product lines; the entire observed price change is assumed to reflect quality change.
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From page 148... ...
for prescription pharmaceuticals for which the Boskin commission estimated a 2.0 percent per year bias led BLS, in 1995, to change its method of pricing prescription drugs when generic versions become available. Also, beginning in January 1997, BLS adopted the PPI (Producer Price Index)
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From page 149... ...
This is not our concern here: in general, hedonic functions are reduced-form reflections of details of tastes, technologies, endowments, and strategic behavior in differentiated product markets. In particular, when competition is imperfect, it is generally not possible to infer marginal costs from the observed hedonic functions.
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From page 150... ...
Hedonic functions are typically refit only periodically, so neither the current period nor the prior period function is usually available. Thus, the backwardlooking method is rarely feasible.
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From page 151... ...
The Direct Time Dummy Method This method involves estimating hedonic functions of the following form: loopy ~ ~ = haze ~ ~ + ~,B~t, r)
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From page 152... ...
prices Pit, and quantities sold -tit. The direct characteristics method computes price relatives using these data without necessarily imposing the assumption (which underlies the time dummy method)
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From page 153... ...
, to obtain a Fisherlike measure of the price relative for this product. Note again that if price ratios for all varieties are the same, as assumed by the time dummy method, all of these measures are equal.
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From page 154... ...
For our single consumer, the price relative could naturally be computed as either h2(zi)
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