Specific CPI Issues: Quality Adjustment

1. Specific CPI Issues: Quality Adjustment Mick Silver Joint SEACEN-IFC-BIS workshop on Inflation measurement: central bank perspectives 12-15 October 2009. The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

2. Five problems: • A temporary missing item problem • A seasonal item problem • A permanently missing item problem - quality adjustment • A sampling problem – new models are introduced and old ones disappear • A new products problem

3. Why are Quality Adjustments (QA’s) Important? • Affects adjustments made using the price index • if quality is increasing (decreasing), but not removed from the index, it will overstate (understate) price change • any adjustments made using the index (e.g., as deflators) will result in understated volume changes if the quality change is positive • alternatively, any adjustments to payments (e.g., cost of living increases) will result in overstated price changes if the quality change is positive

4. Price statisticians do take account of quality changes • They use the matched models method: • sampled models (varieties) selected using detailed product descriptions on “initiation” • prices are recorded in initial month, and monitored in subsequent months • like is compared with like.

5. Importance of price collector Price collectors need codes for: • temporarily missing • seasonal • permanently missing • replacement variety’s price • comparable • non-comparable • previous period’s price (overlap) • explicit adjustment

6. Imputation Techniques for temporary missing prices • Calculate change in average price from matchedobservations using short-term (geometric mean) price changes. • Estimate the price for the missing observations and mark them as “imputed.” • Best using similar varieties – targeted or class mean imputation – than overall mean imputation. • If prices are missing for several months, an imputation should be made for every month until a replacement is found, but not too long (e.g. 3 months).

7. Carry forward • Induces undue stability into the index, especially for high inflation countries. • Not for use unless assured prices do not change

8. Permanently missing varieties • Comparable replacement • Simply compare price of replacement with previous price • Requires well trained price collectors

9. Permanently missing: no comparable replacement • Alternatives: Direct or Indirect Quality Adjustments • Direct Quality Adjustment • data collector or analyst knowledge, • information from producers, or • hedonic regression models • Indirect Quality Adjustments with Imputations • overlap price available • overall mean imputation • class mean imputation

10. Alternative methods of quality adjustment Implicit methods: • overall mean/targeted mean imputation • comparable replacement • overlap • carry-forward Explicit methods: • expert judgment • quantity adjustment • differences in production/option costs • hedonic approach Even if you do nothing you make an implicit quality adjustment.

11. Differentiated items with high rates of model turnover: jan feb mar apr may jun A x x x x x x B x x x C x x x D x x x x E x x x x x x F x x x

12. Overall mean/targeted mean imputation • The overall mean imputation is the computationally straightforward. It is based on the assumption of similar price movements. • A targetedform of the method would use similar price movements - sample size. • The class mean imputed price changes are based on products whose replacement price has benefited from a quality adjustment or the new replacement product has been judged to be directly comparable. • The imputation bias depends on the ratio of unavailable values and the difference between the mean price change for existing products and missing ones.

13. Comparable replacement • The method relies on the efficacy of the respondents and, in turn, on the adequacy of the specifications used as a description of the price basis. • There is an incentive to assume replacements are comparable.

14. Overlap method • Measures the ratio, in a common overlap period, of the prices of the old and replacement product prices. This is taken to be an indicator of their quality differences. • The assumption is that the quality difference in any period equates to the price difference at the time of the splice. • The timing of the switch is thus crucial – product life cycles. • The quality difference is not related to technical specifications or resource-costs, but to the relative prices. • The overlap method is implicitly employed when samples of products are rotated.

15. Carry forward • Induces undue stability into the index, especially for high inflation countries.

16. Expert opinion • Industry specialists • Delphi method • Objective methods much preferred.

17. Quantity adjustment • Such scaling is most important. It should not be the case that, for example, because an industrial lubricant is now sold in 5 litre containers instead of 2.5 litre ones, that prices have doubled. • Production of a bottle of 100 pills each having 50 milligrams of a drug may not be comparable to a bottle of 50 pills of 100 milligrams, even though both bottles contain 5,000 milligrams of the same drug - non-linearities.

18. Differences in production/option costs • Production costs - particularly appropriate - exclude mark ups and indirect taxes • Internet valuation of attributes • Option costs - the cost of producing something as standard may be lower than when it was an option. - the option may be valued at say an additional x when sold separately. However, when it is sold as standard many of the purchasers will not value it so highly, since these were the very ones who chose the standard one. – otherwise similar to quantity adjustment:

19. Hedonics A set of (zk= 1,….,K) characteristics of the models are identified and data over i=1,…,N models are collected. A hedonic regression of the (log) price of model i, pi , on its set of quality characteristics zki is given by:

22. Sample space and item replacement/ substitution • The matching of prices of identical items over time, by its nature, is likely to lead to the monitoring of a sample of items increasingly unrepresentative of the population of transactions. • Respondents may keep with their selected items until they are no longer produced, i.e., continue to monitor old items with unusual price changes and limited sales. • Yet on item replacement, respondents may select unpopular comparable items to avoid explicit quality adjustments; obsolete items with unusual price changes are replaced by near obsolete items with again, unusual price changes. • The substitution of an item with relatively high sales for an obsolete one has its own problems, since the difference in quality is likely to be substantial and substantive, beyond that which can be attributed to, say, the price difference in some overlap period.

23. The New Goods Problem • Use of a Fixed-Base Price Index • A fixed basket does not allow for the immediate inclusion of new goods • New products are continually introduced and some are introduced through product replacements • Such replacements are not timely because the new product most likely has been in the market place for awhile

24. The New Goods Problem • The market life-cycle for new goods is that they are introduced at initially high prices and then proceed to decline in price over time • These price declines are not captured in the price indices resulting in an upward bias

25. Possible Solutions to the New Goods Problem • More frequent review and updates to the weight structure and product samples • Estimation and aggregation structure that allows for introduction of new products • Sample rotation and augmentation • Hicksean reservation price

26. United States • The Boskin Report asserted an upward bias of 0.6 percent • Moulton JEP 1996: The direct quality adjustments and implicit quality adjustments due to linkage can be significant: for example, the change in the price index for new cars from 1967 to 1994 would have been 80 percent greater if no adjustments had been made for quality improvements. • The BLS estimates that • the hedonic quality adjustments introduced since 1998 have had an upward impact in five item categories and a downward impact in five. The overall impact of these newly introduced hedonic models has been quite modest and in an upward direction: only about 0.005 percent per year. • the effects of hedonics compared with completely omitting any quotes where there was a quality change for the video and audio equipment categories (basically a matched model approach). This study used data from December 2002 to February 2005. Annual difference was 1.94 percentage points for televisions. • for March 2004 to September 2004 use of attributes from internet for quality adjustment for computers yielded annualised 9.78 percent fall as opposed to 6.60 percent fall by removing all substitutions.