At What Price?

Conceptualizing and Measuring Cost-of-Living and Price Indexes

Panel on Conceptual, Measurement, and Other Statistical Issues in Developing Cost-of-Living Indexes

Charles L. Schultze and Christopher Mackie, Editors

Committee on National Statistics

Division of Behavioral and Social Sciences and Education

National Research Council

NATIONAL ACADEMY PRESS
Washington, DC



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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes At What Price? Conceptualizing and Measuring Cost-of-Living and Price Indexes Panel on Conceptual, Measurement, and Other Statistical Issues in Developing Cost-of-Living Indexes Charles L. Schultze and Christopher Mackie, Editors Committee on National Statistics Division of Behavioral and Social Sciences and Education National Research Council NATIONAL ACADEMY PRESS Washington, DC

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes NATIONAL ACADEMY PRESS 2101 Constitution Avenue, NW Washington, DC 20418 NOTICE: The project that is the subject of this report was approved by the Governing Board of the National Research Council, whose members are drawn from the councils of the National Academy of Sciences, the National Academy of Engineering, and the Institute of Medicine. The members of the committee responsible for the report were chosen for their special competences and with regard for appropriate balance. This study was supported by Contract No. J-9-J-8-0039 between the National Academy of Sciences and the Bureau of Labor Statistics. Support of the work of the Committee on National Statistics is provided by a consortium of federal agencies through a grant from the National Science Foundation (Number SBR-9709489). Any opinions, findings, conclusions, or recommendations expressed in this publication are those of the author(s) and do not necessarily reflect the views of the organizations or agencies that provided support for the project. Library of Congress Cataloging-in-Publication Data At what price? : conceptualizing and measuring cost-of-living and price indexes / Panel on Conceptual, Measurement, and Other Statistical Issues in Developing Cost-of-Living Indexes ; Charles L. Schultze and Christopher Mackie, editors. p. cm. “Committee on National Statistics, Division of Behavioral and Social Sciences and Education.” Includes bibliographical references and index. ISBN 0-309-07442-8 (hardcover) 1. Consumer price indexes—United States. 2. Cost and standard of living—United States—Statistical methods. 3. Prices—United States—Statistical methods. 4. Economic indicators—United States. 5. Index numbers (Economics) I. Schultze, Charles L. II. Mackie, Christopher D. III. National Research Council (U.S.). Panel on Conceptual, Measurement, and Other Statistical Issues in Developing Cost-of-Living Indexes. HB235.U6 A86 2002 338.5'28'0973—dc21 2001007411 Additional copies of this report are available from the National Academy Press, 2101 Constitution Avenue, NW, Lockbox 285, Washington, DC 20055; (800) 624-6242 or (202) 334-3313 (in the Washington metropolitan area); Internet, http://www.nap.edu Printed in the United States of America Copyright 2002 by the National Academy of Sciences. All rights reserved. Suggested citation: National Research Council. (2002). At What Price? Conceptualizing and Measuring Cost-of-Living and Price Indexes. Panel on Conceptual, Measurement, and Other Statistical Issues in Developing Cost-of-Living Indexes, Charles L. Schultze and Christopher Mackie, Editors. Committee on National Statistics, Division of Behavioral and Social Sciences and Education. Washington, DC: National Academy Press.

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes THE NATIONAL ACADEMIES National Academy of Sciences National Academy of Engineering Institute of Medicine National Research Council The National Academy of Sciences is a private, nonprofit, self-perpetuating society of distinguished scholars engaged in scientific and engineering research, dedicated to the furtherance of science and technology and to their use for the general welfare. Upon the authority of the charter granted to it by the Congress in 1863, the Academy has a mandate that requires it to advise the federal government on scientific and technical matters. Dr. Bruce M. Alberts is president of the National Academy of Sciences. The National Academy of Engineering was established in 1964, under the charter of the National Academy of Sciences, as a parallel organization of outstanding engineers. It is autonomous in its administration and in the selection of its members, sharing with the National Academy of Sciences the responsibility for advising the federal government. The National Academy of Engineering also sponsors engineering programs aimed at meeting national needs, encourages education and research, and recognizes the superior achievements of engineers. Dr. Wm. A. Wulf is president of the National Academy of Engineering. The Institute of Medicine was established in 1970 by the National Academy of Sciences to secure the services of eminent members of appropriate professions in the examination of policy matters pertaining to the health of the public. The Institute acts under the responsibility given to the National Academy of Sciences by its congressional charter to be an adviser to the federal government and, upon its own initiative, to identify issues of medical care, research, and education. Dr. Kenneth I. Shine is president of the Institute of Medicine. The National Research Council was organized by the National Academy of Sciences in 1916 to associate the broad community of science and technology with the Academy’s purposes of furthering knowledge and advising the federal government. Functioning in accordance with general policies determined by the Academy, the Council has become the principal operating agency of both the National Academy of Sciences and the National Academy of Engineering in providing services to the government, the public, and the scientific and engineering communities. The Council is administered jointly by both Academies and the Institute of Medicine. Dr. Bruce M. Alberts and Dr. Wm. A. Wulf are chairman and vice chairman, respectively, of the National Research Council.

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes PANEL ON CONCEPTUAL, MEASUREMENT, AND OTHER STATISTICAL ISSUES IN DEVELOPING COST-OF-LIVING INDEXES CHARLES L. SCHULTZE (Chair), Brookings Institution, Washington, DC ERNST R. BERNDT, Sloan School of Management, Massachusetts Institute of Technology ANGUS DEATON, Woodrow Wilson School, Princeton University ERWIN DIEWERT, Department of Economics, University of British Columbia CLAUDIA D. GOLDIN, Department of Economics, Harvard University ZVI GRILICHES,* Department of Economics, Harvard University CHRISTOPHER JENCKS, John F. Kennedy School of Government, Harvard University ALBERT MADANSKY, Graduate School of Business, University of Chicago VAN DOORN OOMS, Committee for Economic Development, Washington, DC ROBERT A. POLLAK, John M. Olin School of Business, Washington University, St. Louis RICHARD L. SCHMALENSEE, Sloan School of Management, Massachusetts Institute of Technology NORBERT SCHWARZ, Institute for Social Research, University of Michigan KIRK WOLTER, National Opinion Research Center, Chicago CHRISTOPHER MACKIE, Study Director CONSTANCE F. CITRO, Senior Program Officer MICHAEL SIRI, Project Assistant *   Died 1999.

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes COMMITTEE ON NATIONAL STATISTICS 2001 JOHN E. ROLPH (Chair), Marshall School of Business, University of Southern California JOSEPH G. ALTONJI, Department of Economics, Northwestern University LAWRENCE D. BROWN, Department of Statistics, University of Pennsylvania JULIE DAVANZO, RAND, Santa Monica, California ROBERT M. GROVES, Joint Program in Survey Methodology, University of Maryland, College Park JOEL HOROWITZ, Department of Economics, University of Iowa HERMANN HABERMANN, Statistics Division, United Nations WILLIAM KALSBEEK, Department of Biostatistics, University of North Carolina RODERICK J.A. LITTLE, School of Public Health, University of Michigan THOMAS A. LOUIS, RAND, Arlington, VA DARYL PREGIBON, AT&T Laboratories-Research, Florham Park, NJ FRANCISCO J. SAMANIEGO, Division of Statistics, University of California, Davis RICHARD L. SCHMALENSEE, Sloan School of Management, Massachusetts Institute of Technology MATTHEW D. SHAPIRO, Department of Economics, University of Michigan ANDREW A. WHITE, Director

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes Acknowledgments The panel’s report is the result of the efforts of many people. The project was sponsored by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor and also, in part, by the many federal agencies that support the Committee on National Statistics through the National Science Foundation. Throughout the study, the panel received unflagging cooperation from the dedicated staff of BLS. In particular Dennis Fixler (now with the Bureau of Economic Analysis, BEA) and John Greenlees gave generously of their time to educate the panel about the methodology and procedures of the Consumer Price Index. Former Commissioner Katharine Abraham, Mary McCarthy, Charles Mason, Ken Dalton, Dan Ginsburg, Walter Lane, Sylvia Leaver, and Paul Liegey attended meetings, gave briefings, or prepared research materials for the panel. The panel is also indebted to others who made presentations on data and methodological issues, thereby helping us to develop a broad-based understanding of elements that go into the making of price and cost-of-living indexes: David Cutler, Harvard; John Astin, Eurostat; William Nordhaus, Yale; Alan Blinder, Princeton; and Ariel Pakes, Harvard, all served in this capacity. Others, including Kathleen Scholl, U.S. General Accounting Office; Mick Silver, Cardiff University; Tom Palley, AFL-CIO; and Joe Newhouse, Harvard, supplied the panel with helpful information and suggestions. We offer special thanks to Jack Triplett, formerly of BEA and BLS, for attending early meetings and using his long experience and deep knowledge of the major issues to help us get started and plot our course. No panel with a task as difficult as ours could perform its duties without an excellent and well-managed staff: Andy White, director of the Committee on

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes National Statistics (CNSTAT) was responsible for seeing that this was the case. Miron Straf, the former director, was instrumental in developing the study. Project assistants Joshua Dick, Julia Kisa, and Michael Siri provided excellent administrative assistance. Constance Citro, senior project officer, provided experienced and wise counsel throughout the life of the panel. The report also benefitted substantially from the work of Eugenia Grohman, associate director for reports in the Division of Behavioral and Social Sciences and Education, who was responsible for editing the report and who also made valuable suggestions about its structure. We thank her for this and also for her role in overseeing the review process. The panel owes an especial debt of gratitude to Christopher Mackie, CNSTAT study director for the project. He quickly absorbed the relevant professional literature and steeped himself in the issues. He helped organize our work, coordinated and provided insightful comments on papers and drafts covering a wide range of topics, contributed to our substantive discussions, drafted important parts of the report in cooperation with various panel members, and shepherded the report through the review process. This report has been reviewed in draft form by individuals chosen for their diverse perspectives and technical expertise, in accordance with procedures approved by the Report Review Committee of the National Research Council (NRC). The purpose of this independent review is to provide candid and critical comments that will assist the institution in making the published report as sound as possible and to ensure that the report meets institutional standards for objectivity, evidence, and responsiveness to the study charge. The review comments and draft manuscript remain confidential to protect the integrity of the deliberative process. We thank the following individuals for their participation in the review of this report: Ellen R. Dulberger, Business Strategy, IBM Global Services, Somers, NY; Charles Engel, Department of Economics, University of Wisconsin; Robert Feenstra, Department of Economics, University of California, Davis; Ariel Pakes, Department of Economics, Harvard University; Marshall Reinsdorf, Bureau of Economic Analysis, U.S. Department of Commerce; Matthew D. Shapiro, Department of Economics and Survey Research Center, University of Michigan; and Richard Valliant, Westat, Rockville, MD. Although the reviewers listed above have provided many constructive comments and suggestions, they were not asked to endorse the conclusions or recommendations; nor did they see the final draft of the report before its release. The review of this report was overseen by John Geweke, Department of Economics, University of Iowa, and Christopher Sims, Department of Economics, Princeton University. Appointed by the NRC, they were responsible for making certain that an independent examination of this report was carried out in accordance with institutional procedures and that all review comments were carefully considered.

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes Responsibility for the final content of this report rests entirely with the authoring panel and the institution. This report reflects the collective expertise and commitment of the individual members of the panel. All participated in the panel’s many meetings and discussions and in the drafting and reviewing of sections of the report. Each member brought a critical perspective and I thank them for their hard work and dedication to service for public benefit. Finally, the substance of this report and its many antecedents owe much to Zvi Griliches. He was a prominent contributor to the literature on many of the issues with which the panel wrestled, and he pioneered in exploring ways to deal with the thorniest issue of all, the problem of quality change. Zvi was a member of the panel but died November 4, 1999, shortly after the group began deliberations. I speak for the entire panel in saluting his monumental contributions in this area. We will miss him. Charles L. Schultze, Chair Panel on Conceptual, Measurement, and Other Statistical Issues in Developing Cost-of-Living Indexes

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes Contents     EXECUTIVE SUMMARY   1     A COGI Versus a COLI,   2     The Scope or Domain of the Index,   3     Aggregation,   4     Accounting for Substitution Behavior,   5     Quality Change,   6     New Goods,   7     Outlets,   8     Pricing Medical Care,   9     Index Design and Index Purpose,   10     Data Collection,   11 1   INTRODUCTION   13     Background,   13     Panel Charge and Report Organization,   17     Alternative Approaches: A COGI Versus a COLI,   18     Domain of the CPI,   19     Substitution,   21     Aggregation,   26     Changes in the Quality of Goods,   27     New Goods,   30     Outlet Substitution,   32     Stocks and Flows,   33     Index Purpose and Design,   35     Data Collection,   36

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes 2   CONCEPTUAL FOUNDATIONS FOR PRICE AND COST-OF-LIVING INDEXES   38     Setting the Stage: What Are Price Indexes?,   41     The Theory of Price Indexes and Its Critics,   43     Two Perspectives,   57     Conclusions,   73     Technical Note: A Mathematical Approach to Price Indexes,   74 3   INDEX DOMAIN   94     An Unconditional COLI: Conceptual Issues,   96     Measurement Problems,   98     Supplemental Indexes and Satellite Accounts,   101     Other Domain Issues,   102     Conclusion and Recommendation,   105 4   EVOLVING MARKET BASKETS: ADJUSTING INDEXES TO ACCOUNT FOR QUALITY CHANGE   106     COLI and COGI Views of the Quality Change Problem,   109     Evidence from the Boskin Commission Report,   112     BLS Approaches to Quality Changes,   114     Hedonic Regression Methods,   122     Cautions and Recommendations,   140     Technical Note 1: Boskin Commission Estimates of Quality Change and New Goods Bias,   146     Technical Note 2: Mathematical Description of Hedonic Methods,   149 5   NEW GOODS AND NEW OUTLETS   155     New Goods,   155     New Outlets,   167 6   THE SPECIAL CASE OF MEDICAL SERVICES   178     Background,   178     Conceptual and Measurement Issues,   181     The Domain of Consumer Health Expenditures: Employers’ Health Insurance Payments,   185     Direct Pricing of Health Insurance,   186     Recommendations,   188 7   INDEX DESIGN AND INDEX PURPOSE   191     Indexing Public Transfer Payments,   192     Wage Bargains and Indexed Wages,   207     Indexing Private Contracts,   208     Inflation-Indexed Treasury Securities,   210

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes     Indexing the Federal Income Tax System,   212     Measuring Output Changes,   214     Inflation Indicators for Macroeconomic Policy,   216     Technical Note: The CPI Versus the NIPA Price Index as an Inflation Measure,   219 8   WHOSE INDEX? AGGREGATING ACROSS HOUSEHOLDS   222     Two Kinds of Heterogeneity,   223     Heterogeneity in Prices Paid and in Rates of Inflation,   225     The Consequences of Heterogeneity for Index Construction,   226     Group Indexes: Why the Current Data Collection System Cannot Produce Them,   226     A Price Index for the Elderly?,   228     The Conceptual Basis for Group Indexes,   229     How Might Data for Subgroup Indexes Be Assembled and What Would It Cost?,   232     Suggested Research and Testing,   235     Plutocratic Versus Democratic Weights,   237     Summary and Recommendation,   240     Technical Note 1: Aggregation and the “Representative Consumer,”   241     Technical Note 2: Do Inflation Rates Differ by Age or Income Group?,   246 9   DATA COLLECTION FOR CPI CONSTRUCTION   252     The Current Data Collection Process,   253     Alternative Data Collection Approaches,   264     Summary and Recommendations,   274     Technical Note: Additional Description of CPI Data Inputs,   276     APPENDIX: STATISTICAL DEFINITION AND ESTIMATION OF PRICE INDEXES   283     REFERENCES   293     GLOSSARY   307     BIOGRAPHICAL SKETCHES OF PANEL MEMBERS AND STAFF   315     INDEX   319

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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes At What Price? Conceptualizing and Measuring Cost-of-Living and Price Indexes

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