system—with a specific vector of characteristics z1 and price p1—disappears and is replaced by another—with “similar” characteristics z2 and price p2. 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. It is possible and, for reasons of data availability, often necessary to base these adjustments on a hedonic function that is estimated with data from a period well before the substitution occurs.

Though the difficult econometric problems that plague all hedonic analysis—e.g., identifying appropriate functional form and relevant product characteristics—complicate the indirect method, it has considerable commonsense appeal, at least relative to the alternatives: using the price relative (p2/p1) with no adjustment for quality change, assuming that the observed price change is due entirely to quality change, or adjusting for quality using one of the standard replacement methods. The fact that, among hedonics approaches, the indirect method is the least demanding in terms of data and procedure adds to its practicality. It simply requires using cross-sectional price and model characteristics data (similar to that which BLS already tracks) to estimate hedonic functions periodically.19 This function can then be used to estimate the price that would have been charged in the period studied for new models (with the same characteristics but different quantities of them) that are to be brought into the index (see “Technical Note 2” below). In contrasting alternative hedonics approaches, it is imperative to understand that the indirect method is applied by BLS in a comparatively narrow manner—to adjust price quotes, gathered under normal procedures, of replacements for items that have permanently disappeared from a sample outlet. For most products that are now hedonically adjusted (all by the indirect method), the monthly number of quotes adjusted is quite small, as is the effect on the monthly index for the relevant stratum.

Direct Methods

Two distinct direct hedonic adjustment approaches have been developed: the direct time dummy method and the direct characteristics method. In the direct time dummy method, data from multiple periods are used to estimate coefficients of a function relating the logarithm of price to a set of product characteristics and a set of 0-1 dummy variables for the periods covered.20 As discussed below, this

19  

Though the type of data required are similar, BLS typically has needed to expand its sample, or purchase commercial data, in order to generate a sufficient number of price points to estimate the hedonic models recently introduced into the CPI process.

20  

Work on the time dummy method has mainly been developed in the academic literature. Key studies include Griliches (1990), Triplett (1990), Berndt et al. (1995), and Arguea et al. (1994).



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