discuss them adequately, and some of these methods over-adjust for quality change, so that improving quality can generate downward bias in the CPI.”

Essentially, BLS methods for adjusting observed prices of items that have undergone significant quality change, as judged by a commodity analyst, borrow information about price changes observed for similar items. For example, say a new improved microwave oven replaces the old model at a CPI outlet. Under one method, BLS will assume that the pure price portion of an observed price change between the old and new models is the same, in percentage terms, as that for other microwave ovens. Any remaining price difference is attributed to quality change. Such a method would implicitly overstate the effect of quality (and impart a downward bias on the CPI) if, for instance, manufacturers tend to increase prices (beyond those that cover costs of implementing improvements) when they roll out new models. We lay out BLS quality adjustment methods and examine potential biases in greater detail below.

CPI Item Replacement Methods

As noted at the beginning of this chapter, the manner in which goods (and services) appear and disappear can take a number of forms: old models are replaced by new ones that are nearly identical; new models are introduced that embody clear improvements over their predecessors; models may display qualitative change in existing features or may introduce altogether new features. To accommodate some of these differences and to overcome data and procedural limitations, BLS employs alternative methods, shown in Table 4-1, for treating replacement item price quotes.

For cases in which a sample item is replaced, the observed price change must be (1) considered a pure price change (e.g., simple repackaging), (2) attributed entirely to quality differences, or (3) attributed partly to price change and partly to quality change (Kokoski, 1993). Cases 2 and 3 require adjusting observed prices prior to inclusion in the index; all three require judgments by BLS commodity analysts.

Case 1 results in what BLS calls “direct comparison,” which applies when the replaced and replacement items are determined to be comparable by the commodity analyst. A repackaged food item or a new color of shirt are examples. Direct comparison is essentially item replacement for cases in which adjustment to the observed price has been deemed unnecessary. As Table 4-1 indicates, this is the most common finding. According to Moulton and Moses (1997), for 1995 about 65 percent of item replacements were in this category.

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. The Boskin commission wrote that direct comparison, which it called “comparable substitution,” likely imparts an upward bias to the index since “in practice most goods tend to

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