. "4 Evolving Market Baskets: Adjusting Indexes to Account for Quality Change." At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes. Washington, DC: The National Academies Press, 2002.
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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes
It may be impossible to measure the value, even for just one consumer, created by the change from black and white to color television, by an increase in the user friendliness of computers, or by the addition of antismog devices to automobiles.
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. If the underlying index methodology is unable to disentangle the quality-driven price movement from the “pure” price movement, living standards cannot be held constant. Second, techniques must keep the composite of index items—which is in constant churn—relevant to consumers’ material well-being. The addition of new goods into the marketplace generally raises (and the elimination of goods lowers) the welfare of some consumers; until the new good is represented, this welfare change is not reflected in the price index.3
The cost-of-living approach provides a theoretical framework for thinking about problems associated with the changing nature of goods and services available in the market. If a rational consumer buys two varieties of some product— apples, for instance—in some (relatively short) period, economic theory asserts that the ratio of their prices measures their relative qualities, at least at the margin.4 The next logical step is to assume that such price ratios provide meaningful measures of relative qualities even if there are many consumers and some do not purchase both products simultaneously. This assumption may be misleading when notions of quality differ across consumers, since demographic changes may then shift relative prices without quality change. Without this assumption, however, there is no way to use market data to recognize that, for instance, replacing a low-price variety with a high-price variety can make all consumers better off if the new variety is of sufficiently higher quality. More generally, if the quality of goods improves on balance over time, a cost-of-living index will discount some of the nominal price increases that occur, and the overall price index will rise more slowly than the average of the unadjusted prices.
Hausman (1997) has argued that the CPI is also biased as a cost-of-living estimator because, to the extent that consumers value variety, it makes no allowance for increases in the number of choices within index categories. Conceptually, this assertion is hard to dispute—if for no other reason than greater variety permits better matching to individual tastes, which gives some people pleasure directly. On the other hand, the existence of greater variety may, in some cases, be welfare decreasing if it creates increased search costs. There is no known way to capture such effects accurately in regular index production.
In practice, of course, it is often a matter of judgment as to whether one is dealing with two varieties of the same product or two different products that happen to be relatively close substitutes. Also, as the number of varieties multiplies, the act of choosing itself may require more time and effort.