Quality adjustment: a review of some methods with examples from clothing Presented by Marc Prud’Homme Chief of Research on Consumer Prices Prepared for the ILO/UNECE workshop series May 2010

23/10/ Statistics Canada Statistique Canada Outline  Introduction  Some theory  Methods of quality adjustment Quality adjustment techniques Evaluations Recommended quality adjustment methods  Clothing Overview The Canadian Experience Hedonic model for clothing  Final thoughts

Introduction  The measurement of price change is complicated by the appearance of new products and the disappearance of old products.  Existing products also change. Price levels are affected Price changes are affected  Improper treatment = BIAS  Quality bias occurs when the price change is not accurately separated from the quality change.  Boskin = 0.60 / 1.10 (percent points per annum) 23/10/ Statistics Canada Statistique Canada

The theory  CPI: A consumer price index measures a price change for a constant market basket of goods and services from one period to the next.  A temporal price index (e.g., CPI) should be an estimate of “pure” price change.  Matched sampling is used to “hit” this target. 23/10/ Statistics Canada Statistique Canada

The theory  Matched sample: a sample in which the items selected for analysis share all properties (characteristics) except that under investigation (price).  MS holds constant the quality of the products that have been selected for the index.  To keep quality changes from influencing the price index, specifications of the articles to be priced are of crucial importance.  In practice, a matched sample is a “dream” and the reality is a “nightmare”. Products disappear Products change 23/10/ Statistics Canada Statistique Canada

The theory  If the disappearance is expected to be short lived then there is no major issue.  If not then a different approach must be used which often consist of replacing the items with a substitute.  If the substitute is of the same quality as the one to be replaced the price of the substitute can be used instead of the old one. 23/10/ Statistics Canada Statistique Canada

The theory  If there is a difference in quality between the old and the new item then an adjustment is needed.  The next section presents an overview of various quality adjustment methods. 23/10/ Statistics Canada Statistique Canada

The theory (guiding principles)  Quality is a pervasive concept.  Quality adjustment is more an ART than a science.  Hulten (1997): “from a strictly theoretical standpoint, no natural economic concept of quality exists.” 23/10/ Statistics Canada Statistique Canada

The theory (guiding principles)  DO NOT assume automatically… … That all price change is a reflection of the change in quality. … That products with different qualities are essentially equivalent. 23/10/ Statistics Canada Statistique Canada

Quality adjustment methods  Explicit (or direct) quality adjustment methods directly estimate the value of the quality difference between the old and new product and adjusts one of the prices accordingly.  Implicit (or indirect) quality adjustment methods estimate the pure price change component of the price difference between the old and new products based on the price changes observed for similar products. 23/10/ Statistics Canada Statistique Canada

Quality adjustment methods  Implicit QA methods Direct price comparison Overlap Overall mean imputation Class mean imputation Linked-to-show-no-price- change Matched model 23/10/ Statistics Canada Statistique Canada  Explicit QA methods Expert valuation Production costs Quantity adjustment Option cost Hedonics

Jevons price index formula 23/10/ Statistics Canada Statistique Canada

IMPLICIT QUALITY ADJUSTMENT METHODS 23/10/ Statistics Canada Statistique Canada

Direct price comparison  A simple approach where the price of the new product in the current period is directly compared with the price of the old product from the previous period.  Assumes no quality difference and the products are perfectly comparable. 23/10/ Statistics Canada Statistique Canada

1. Direct price comparison 23/10/ Statistics Canada Statistique Canada PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 ITEM X ITEM Y ITEM Z10014 N/A ITEM R (Replacement) All

Direct price comparison: evaluation  In the absence of any information on the new product, it can be the only choice.  Used when the quality difference are subtle or not valued by consumers. 23/10/ Statistics Canada Statistique Canada

2. Overlap method 23/10/ Statistics Canada Statistique Canada  When the old item and the replacement exist simultaneously on the market.  The price change from period t - 1to t is measured using the price of the old item.  The price change from period t to t + 1 is measured using the price of the replacement item.  Assumption: The price difference between the old and new products reflect the value of the quality difference.

2. Overlap method 23/10/ Statistics Canada Statistique Canada PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 ITEM X ITEM Y ITEM Z10014N/A ITEM R (Replacement) All

Overlap method: evaluation  Simple and easy to implement.  Acceptable if it is believed that the price ratio reflects the quality ratio.  This is a reasonable assumption If your are pricing the same item but in a different store. Reasonable assumption in competitive markets.  Absence of necessary data  Few quantities available (end-of-cycle)  Perverse results depending on current marketing strategies 23/10/ Statistics Canada Statistique Canada

Overall mean imputation  When the price of the missing item is not known, an estimate of the price for the missing item is made.  An overlap price is imputed for the old item in the current period by taking the price changes between the previous and current periods of items in the same group.  The replacement’s price changes come into the index only in period 3.  Also called the Imputed price change-implicit quality adjustment method or bridged overlap. 23/10/ Statistics Canada Statistique Canada

3. Overall mean imputation 23/10/ Statistics Canada Statistique Canada PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 ITEM X ITEM Y ITEM Z ITEM R (Replacement) n/a 18 n/a All

Overall mean imputation: evaluation  The method assumes that the pure price change from the replaced item to the replacement item is the same for the composite of all items in the group.  This may or may not be true depending on the marketing environment at the time of the imputation.  The price change for the item replacement in the sample is imputed from the “pure” price changes of the other items for which their quality did not change.  An implicit quality adjustment is made. 23/10/ Statistics Canada Statistique Canada

Overall mean imputation: evaluation  The effect is as follows: If quality is improving then the IP-IQ method misses some price change because it inappropriately counts some price change as quality change. If prices are rising, it over adjusts for quality change and vice versa. The direction of the bias depends on the direction of the price change than the direction of the quality change. 23/10/ Statistics Canada Statistique Canada

Overall mean imputation: evaluation  The method should be used when the prices of the items in sample (the market) react in sync.  Should not be used when the prices of the products fluctuate as a result of market conditions. 23/10/ Statistics Canada Statistique Canada

Class mean imputation  Same approach as the Overall mean imputation but the price movement for the missing item is imputed from items in the sample of comparable quality.  Same conclusions as the IP-IQ method, 23/10/ Statistics Canada Statistique Canada

4. Class mean imputation 23/10/ Statistics Canada Statistique Canada PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 ITEM X ITEM Y ITEM Z ITEM R (Replacement) n/a 18 n/a All

Matched model (monthly chaining)  Index is calculated only from the sample of matching items from period to period.  When a replacement is chosen in period t, it is not used in the calculation of the index.  No attempt is made to adjust for any quality difference.  Only the matched items that were in the sample in t – 1 AND t are used.  Generates same result as the IP-IQ method. 23/10/ Statistics Canada Statistique Canada

5. Matched model 23/10/ Statistics Canada Statistique Canada PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 Price in period 3 Price relative Period 3 Price index period 3 ITEM X ITEM Y ITEM Z10014N/A N/A ITEM R (Replacement) 18N/A All

Link-to-show-no-price-change  With the “link-to-show-no-price-change” it is assumed that any price difference from the old model and the new item is explained by their quality disparity. 23/10/ Statistics Canada Statistique Canada

23/10/ Statistics Canada Statistique Canada 6. Link-to-show-no-price-change PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 ITEM X ITEM Y ITEM Z10014n/a ITEM R (Replacement) All

LSNPC: evaluation  The method implies no inflation by assuming that all price change between the old and the new model is the result of quality differences.  The index is biased downward when prices are rising and vice versa.  Method which makes it difficult to isolate the pure price change.  EEC forbids its use. 23/10/ Statistics Canada Statistique Canada

Results compared MethodPrice changeQuality change Direct comparison28.6%0% Overlap method/matched model12.5%16.1% Overall mean imputation8.9%19.7% Class mean imputation9.6%19.0% Link with no price change0%28.6% 23/10/ Statistics Canada Statistique Canada

EXPLICIT QUALITY ADJUSTMENT METHODS 23/10/ Statistics Canada Statistique Canada

Explicit quality adjustment methods  Direct adjustment methods Option price Production cost Expert judgement Hedonics  More resource intensive compared to Implicit methods. 23/10/ Statistics Canada Statistique Canada

1. Direct adjustment 23/10/ Statistics Canada Statistique Canada PERIOD Price index period 1 Price in period 1 Price in period 2 Price relative Period 2 Price index period 2 ITEM X ITEM Y ITEM Z10014 N/A ITEM R (Replacement) All Value of the quality difference is $3

Hedonics  Hedonic price index is any price index, which uses information from a hedonic regression. Hedonic regressions describe how a product’s price could be explained by the product's features (or characteristics).  Hedonics have proven to be very useful when applied to information and communication products (e.g. personal computers), because they can help overcome such problems (or challenges) such as new goods and rapid quality change. 23/10/ Statistics Canada Statistique Canada

The model and parameter estimates 23/10/ Statistics Canada Statistique Canada

Hedonics: assumptions  Product characteristics must be quantifiable.  The collection of relevant product characteristics does not change. 23/10/ Statistics Canada Statistique Canada

Hedonics: issues  Functional form  Multicollinearity  Sample size  Coefficients need to be stable 23/10/ Statistics Canada Statistique Canada

Hedonics: possible approaches Estimate the equation and use the coefficients as the “shadow” (or implicit) price of the characteristics. Estimate the hedonic equation in the base period and use it to estimate the price of the product in the comparison period. The difference in price is explained by quality change. 23/10/ Statistics Canada Statistique Canada

23/10/ Statistics Canada Statistique Canada Has the quality changed? Can the quality difference be explicitly quantified? Yes No Continue to use matched sampling Yes Use direct adjustment Manually assess Production costs Expert panels Option costs Hedonics No price difference is due to quality Use direct comparison Overlap method No All price difference is due to quality Are the old item and the new items available simultaneously? Yes No Linked with no price change Overall class mean imputation Is a replacement available? Yes Replacement available No replacement available Carry Forward

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

Before moving on… Each and every instance of commodity substitution is unique and must be carefully considered to ensure that the aim of measuring pure price change is respected, as far as practicable. Which method is used to make the quality assessment must also be considered on a case by case basis. Different approaches generate different results. 23/10/ Statistics Canada Statistique Canada

Clothing 23/10/ Statistics Canada Statistique Canada

Monthly clothing indexes. Jan 2001 to Sept /10/ Statistics Canada Statistique Canada

Monthly clothing indexes. Jan 2001 to Sept /10/ Statistics Canada Statistique Canada

23/10/ Statistics Canada Statistique Canada

Clothing: the issues  The apparel component of the CPI was chosen as the subject of the research described in this article due in part to the difficulty of correctly measuring price change for apparel items and the labor-intensive nature of the microlevel review of price and characteristic data associated with apparel.  Brown and Stockburger, /10/ Statistics Canada Statistique Canada

Clothing: the issues  The seasonal nature of apparel  The large number of item replacements  The need on maintaining a constant-quality price index  Result: resource intensive exercise 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice  Direct approach  Field agents collect the prices and the features of the apparel item on a Quality Price Change Report (QPCR).  The analysts at the head office then decide if the substitute is comparable or not to the replaced item.  They also make the quality valuation.  Examples of a QPCR for clothing at Statistics Canada.  It starts with the item specification. 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice  Item Specification Description Item Name : Women's Shirt 2 Desirable Quantity and Unit of Measure : 1 UT When to Price : Monthly Amendment Notice Number : 802 Amendment Notice Date : /10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice  Item Description: Shirt Misses size range or S, M, L Broadcloth, polyester/cotton or polyester/rayon (viscose) fibre Thread count approx. 128 x 72 per 2.5 cm2 Solid colours including fashion colours Folded over buttoned front 23/10/ Statistics Canada Statistique Canada Back yoke Long sleeves with single cuffs No trim Good workmanship Safety stitch seams Perma-press finish 6 pearlized buttons

Clothing: the Canadian practice  Acceptable Added value features: 100% cotton broadcloth 100% rayon (viscose) One breast pocket Button-down collar Front placket Printed fabric Yarn dyed woven check or striped fabric Moderate amount of trim such as ruffles, piping, etc Double stitched collar Packaged 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice  Acceptable Decreased value feature: Up to 10% lower thread count and 8-10 stitches per 2.5 cm No back yoke Short sleeves Roll up sleeves 5 plastic buttons One piece collar One colour only 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice  Acceptable Deviations: Oxford cloth, Polyester/cotton, Polyester/rayon (viscose) fibre with a thread count of approx. 84 x 50 per 2.5 cm2 with the same styling features may be selected at equal value A dress blouse of 100% polyester in solid colours With moderate lace trim and/or pleating Front buttons (may have placket and/or ties) May be priced but upon selection, specifics must be indicated If, because of a certain characteristic (e.g. fibre content), it is not possible to find an item that exactly meets the specification, if that particular characteristic is mentioned on the checklist, it will be allowed as an acceptable deviation. 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

Clothing: the Canadian practice 23/10/ Statistics Canada Statistique Canada

23/10/ Statistics Canada Statistique Canada

Clothing and hedonics (Liegey 1993)  To calculate the quality adjusted price…  Assume a woman’s coat without lining contained 20% wool and 80% polyester (base variable) was no longer available for pricing.  The replacement now has lining and contains a 40% wool and 60% polyester mix, ceteris paribus.  The value of the lining and the 20% additional wool would be added to the price of the old item.  Constant quality prices are compared.  Polyester is the base, so nothing needs to be done here. 23/10/ Statistics Canada Statistique Canada

Clothing and hedonics (CDA) 23/10/ Statistics Canada Statistique Canada

Clothing and hedonics (CDA) 23/10/ Statistics Canada Statistique Canada  If this model were to be used in quality adjustment we would assess a unit change in the percentage of cotton fibre resulting from substitution at 49 cents.  However, if the brand changed upon substitution from a store brand or a miscellaneous brand to a national/regional brand the quality difference would be assessed at $7.11.  The outlet variables included in this model would not be used in quality adjustment directly, but are present in the model simply to improve its specification.

Clothing and hedonics (CDA) 23/10/ Statistics Canada Statistique Canada  If this model were to be used in quality adjustment we would assess a unit change in the percentage of cotton fibre resulting from substitution at 49 cents.  However, if the brand changed upon substitution from a store brand or a miscellaneous brand to a national/regional brand the quality difference would be assessed at $7.11.  The outlet variables included in this model would not be used in quality adjustment directly, but are present in the model simply to improve its specification.

Final thoughts about clothing  The issue of fashion  Should sale prices be used?  Dutch approach: seasonal baskets  Hedonics 23/10/ Statistics Canada Statistique Canada

The end 23/10/ Statistics Canada Statistique Canada