zero or, conversely, for an item that has disappeared, the increase in price that would have driven quantity demanded to zero? Failure to capture this “price reduction” could be argued to cause a new good introduction bias in the index. The second issue is what to do in subsequent periods after the appearance of the new good. Specifically, how and when should these items be brought into the market basket tracked by the index?
As new products penetrate the market, the item coverage of a fixed-basket index becomes less and less representative of the things that people are currently buying. This is why various techniques of “unfixing” the market basket, including item replacement and sample rotation, are now regular features of the CPI. However, even with the modifications that these techniques allow, potential indexing problems remain. Identifying one of these problems, Hausman (1997:209) argues that welfare effects associated with the introduction of new goods should be estimated and used to adjust the CPI:
The CPI serves as an approximation of an ideal cost-of-living (COL) index. In turn, the COL index answers the question of how much more (or less) income a consumer requires to be as well-off in period 1 as in period 0 given changes in prices, changes in the quality of goods, and the introduction of new goods. . . . The CPI as currently estimated by the Bureau of Labor Statistics (BLS) does a reasonable job of accounting for price changes and has begun to attempt to include quality changes. However, the BLS has not attempted to estimate the effect of the introduction of new goods, despite the recognition of the potential importance of new goods on both a COL index and the CPI.
In this subsection we briefly review the mechanics of how, in theory, price indexes could take into account this new goods effect. We then consider a counterargument to Hausman’s (and, implicitly, the Boskin commission’s) recommendation for BLS to do so.
The relevant difference between a new good and an established one is that, for the former, the price in previous periods associated with the realized sales levels (zero) cannot be observed, while the price for the established good can be. In theory, a virtual price exists in each prior period that would have been just high enough to drive the quantity demanded of the new good to zero.4 There are consumers who would have purchased the good at various prices between that virtual price and the lower price at which the good sells when it appears in