Session 7: Adjustment for quality changes UNECE Workshop on Consumer Price Indices Istanbul, Turkey,10-13 October 2011 Session 7: Adjustment for quality changes Presentation by Carsten Boldsen, UNECE

Overview The problem of quality changes Adjustment for quality changes Useful links Some recommendations

1. The problem of quality changes What is the problem with quality changes? The CPI aims to measure the average price change of a fixed basket of products Changes in the baskets other than price changes should not influence the index ☞ Collected prices need be adjusted for quality changes to ensure the price index is showing only real price changes!

1. The problem of quality changes The goods and services included in the CPI changes in quality over time – some gradually, others in discrete changes The pace of innovation is high, leading to continuous changes in the quality of many products There is no clear or generally agreed definition of what is “quality” – something measurable, or a subjective feature based on perceptions?

1. The problem of quality changes HICP for computers (09.1.3), 2004 = 100

1. The problem of quality changes The Boskin Report estimated 0,6 % point upward bias per year for the US-CPI due too insufficient adjustment for new products and quality changes Countries are using different methods to adjust for quality changes, that may give different results The replacement of products always imply some assumption about the relative qualities of the 2 products – You cannot “do nothing”!

2. Adjustment for quality changes Two types of methods to adjust for quality changes Implicit methods: Explicit methods Direct comparison Option prices Link-to-show-no-price-change Production costs Overlapping prices Expert judgement Imputation Hedonic methods Matched model - monthly re-sampling and chaining

2. Adjustment for quality changes Direct comparison The price of the new product is compared directly with the price of the old one Assumption: the quality is the same, the two products are comparable and the whole price change is included in the index

Direct comparison Jan. Feb. March April Item A 40 42 44 Item B 43 45   Jan. Feb. March April Item A 40 42 44 Item B 43 45 46 47 Item C 48 50 Item D (50) 55 56 Monthly index 100 102,9 105,7 Chained index 108,8 111,9

2. Adjustment for quality changes Evaluation of direct comparison Suitable when the quality difference is subtle or not valued by consumers May be the only choice in absence of any information on the new product Recommended in HICP as default method in lack of specific information

2. Adjustment for quality changes Link-to-show-no-price-change The price of the new product is linked into the index The price change is assumed to equal the quality change and thus not included in the index

Link-to-show-no-change   Jan. Feb. March April Item A 40 42 44 Item B 43 45 46 47 Item C 48 50 Item D (55) 55 56 Monthly index 100 102,9 102,4 Chained index 105,4 108,4

2. Adjustment for quality changes Evaluation of link-to-show-no-change Suitable when the price difference reflects a quality difference Should not be used as default method (not allowed in HICP) as it will bias the index towards no change Particular problematic in periods with high inflation

2. Adjustment for quality changes Overlapping prices With overlapping prices a new product can be linked into the index Assumption: the price difference between the old and new product reflects the value of the quality difference between the two products, and is not included in the index calculation

Overlapping prices Jan. Feb. March April Item A 40 42 44 Item B 43 45   Jan. Feb. March April Item A 40 42 44 Item B 43 45 46 47 Item C 48 50 Item D (52) 55 56 Monthly index 100 102,9 104,3 Chained index 107,4 110,5

2. Adjustment for quality changes Evaluation of overlapping prices Simple and easy to implement, but overlapping data are not always available Reasonable method in competitive markets where price differences reflects quality differences Caution should be made in sales periods and end-of product cycles where there is likely to be real price differences

2. Adjustment for quality changes Overall mean imputation The price change of the new product is estimated by the average price change of the available products in the elementary index, Assumption: the price change is the same as the average price change of the available products for which there were no replacements/no quality changes

Overall mean Imputation Imputation: 55/(42/40*46/45)^(1/2) = 53,09   Jan. Feb. March April Item A 40 42 44 Item B 43 45 46 47 Item C 48 50 Item D (53,09) 55 56 Monthly index 100 102,9 103,6 Chained index 106,6 109,7

2. Adjustment for quality changes Evaluation of overall mean imputation Easy to implement in the CPI calculation system Will often be the best option in absence of specific information about the old and new products Should not be used when prices fluctuates as a result of market conditions Gives same result as if the products with missing prices are left out from the calculation of a monthly chained index:

Overall mean imputation = only matched prices   Jan. Feb. March April Item A 40 42 44 Item B 43 45 46 47 Item C 48 50 Item D 55 56 Monthly index 100 102,9 103,6 Chained index 106,6 109,7 Each month-to-moth index is based only on those products for which a price is observed in both months

Comparison of results Jan. Feb. March April Direct comparison 100   Jan. Feb. March April Direct comparison 100 102,9 108,8 111,9 Link-to-show-no-change 105,4 108,4 Imputation 106,6 109,7 Overlap prices 107,4 110,5

2. Adjustment for quality changes Other imputation methods The missing price can be estimated by use of the price change from another index or by the price development of an available specific similar product from a similar outlet In Class mean imputation the price change is estimated by the quality adjusted price change of those products that experienced a quality change

2. Adjustment for quality changes Matched model – Monthly re-sampling and chaining The index is calculated from month-to-month on basis of the products that have a price in both months only! Requires the sample to be updated on monthly basis to reflect market developments: Include new products, also when there are no missing observations! Assumption: Quality changes are catched by price developments of existing products

Matched model Month 0 Month 1 Month 2 Month 3 Month 4 Item A a0 a1 a2 Item B b0 b1 b2 b3 b4 Item C c0 c1 c2 c3 c4 Item D d1 d2 d3 d4

2. Adjustment for quality changes Evaluation of matched model: Very suitable if the elementary indices are calculated as monthly chained indices Provides good results for competitive markets Requires large and representative sample to be updated on monthly basis

2. Adjustment for quality changes Option prices: If the difference between two models is the inclusion of an extra option, e.g. a CD-ROM drive in a computer, the extra option can be separately priced and appropriate adjustment made in the recorded price Production costs: Producers can be asked about the difference in cost of producing the old and new item, and the ratio of costs be applied for adjusting the prices

2. Adjustment for quality changes Experts judgement: Persons with product knowledge value the difference between the new and old product, and the price change is adjusted accordingly Hedonic adjustments: By use of hedonic regression. P = a + biXi + ei - Suitable for information and communication products - Resource and data demanding - Different version of hedonics are available - Needs re-estimation when new price determining characteristics appear

2. Adjustment for quality changes The Handbook on price and volume measures in national accounts (Eurostat 2001) divides the quality adjustment methods into three groups: A methods: most appropriate methods B methods: those methods, which can be used in case an A method cannot be applied C methods: those methods, which shall not be used The Handbook provides useful guidance & practical examples Eurostat will issue ratings of the methods on case-by-case basis

2. Adjustment for quality changes Use of international price indices is an acceptable (B) method, if they can be considered representative of the price development in the country. Ex: - Energy and raw material prices - Computers For example, US compiled hedonic indices for computers and peripherals available on Internet may be used as a data source, adjusting for exchange rate changes if needed

3. Useful links CPI Manual in English and Russian is available from www.unece.org/stats/archive/02.07.e.htm Supplementary Handbook: Practical Guide to Compiling Consumer Price Indices. Available on www.unece.org/stats/documents/2008.05.cpi2.htm Handbook on price and volume measures in national accounts. Available from Eurostat website Papers from Joint UNECE/ILO Meetings on CPI are available on www.unece.org/stats/archive/docs.date.e.htm Papers from meetings in the Ottawa Group on Price Indices are available from www.ottawagroup.org The Voorburg Group on Services Statistics provides useful information on http://www4.statcan.ca/english/voorburg/

4. Some recommendations Agree on which methods to use on a case-by-case basis A mix of simple, implicit methods usually gives good results – practice in many countries Do not apply “link-to-show-no-change” as default Produce guidelines to staff and price collectors Be transparent - document methods