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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes
BLS collects manufacturers’ estimates of the cost increases incurred in adding or changing observable features in the new model. On the assumption that those costs are reflected in reported motor vehicle prices, the prices are adjusted downward to reflect the quality improvements associated with the changed characteristics. This approach is applied not merely to features that are immediately evident, e.g., adding cruise control as a standard feature, but also to more subtle changes, such as the introduction of more corrosion-resistant metals on exposed surfaces. Quality adjustments for changes in the attributes of gasoline are also made with a cost-based technique.
Hedonic techniques offer an alternative method of direct quality adjustment. In this approach, statistical regressions are applied to estimate how much consumers pay for combinations of observable characteristics embodied in goods. Hedonic techniques have long been used in the CPI to make quality adjustments for clothing and rent. In the case of computers, differences in market prices have been linked to differences in speed, memory, reliability, and other performance indicators. These statistical estimates are then used to quality adjust the prices of the newer replacement goods as they are substituted for older items that disappear from the index. As would be expected, the hedonically adjusted price of computers has been falling rapidly for many years. The BLS has recently extended this approach to other goods, including TVs, microwave ovens, audio equipment, and several other types of appliances, and it is experimenting with hedonic techniques for still more products. The recent expansion in hedonic applications has thus far not had a large effect on the CPI. In Chapter 4 we discuss this phenomenon in detail and describe how it and other factors shape our assessment of the potential of hedonic methods in the CPI.
When a noncomparable replacement for an item that has disappeared cannot be explicitly adjusted by one of the methods described above—and this constitutes the large majority of cases—an implicit adjustment is made. In linking the old item price to the new item price (to calculate the price relative for the month in which the replacement takes place), a “pure” price change is imputed for the new replacement item on the basis of the average price change for similar items. Any remaining difference in price between the new and the old items is assumed to represent a quality change and is ignored (i.e., the assumed value of the quality change is adjusted away and that part of the price difference has no effect on the CPI). Subsequently, the new item is priced each month as are all the other items in the index. The large volume of items that are implicitly adjusted each year for quality change suggests the potentially high value of research directed toward developing reliable methods for widening the applicability of explicit quality adjustment techniques.
The rapid growth of research in hedonic techniques (coupled with the lack of research on alternatives) suggests that they may be the most promising approach for exploiting data on differences in the observable characteristics of similar goods to generate measures of quality change. But, in practice, their application is