United Nations Economic Commission for Europe Statistical Division Producer Price Indices - Recommendations of international manuals Joint EFTA/UNECE/SSCU Seminar July 2007 Presentation by Carsten B. Hansen, UNECE

UNECE Statistical Division Slide 2July 2007 Overview 1.The family of PPIs 2.The international manuals 3.Calculation of the PPI 4.Basic measures 5.Quality adjustments

UNECE Statistical Division Slide 3July 2007 The family of PPIs Producer price indices Output PPIs Input PPIs PPI – Production for the domestic market PPI – Production for export PPI – Total production PPI – Input from the domestic market PPI – Total input PPI – Input from imports

UNECE Statistical Division Slide 4July 2007 The international manuals  Producer Price Index Manual. Theory and Practice (2004). Electronic version available on  Export and Import Price index Manual – planned to be published late 2007/early Draft chapters available on

UNECE Statistical Division Slide 5July Introduction 2.Background and uses of PPIs 3.Coverage and classifications 4.Weights and their sources 5.Sampling 6.Price collection 7.Treatment of quality change 8.Item substitution and new products 9.PPI calculation in practice 10.Treatment of specific products 11.Errors and bias in the PPI 12.Organization & management 13.Publication and dissemination 14.The system of price statistics 15.Basic index number theory 16.Axiomatic and stochastic approaches 17.The economic approach 18.Aggregation issues 19.Price index using an artificial data set 20.Elementary indices 21.Quality change and hedonics 22.Seasonal products Overview of the PPI Manual

UNECE Statistical Division Slide 6July 2007 Calculation of elementary indices Elementary price indices can be calculated as Unweighted averages: The arithmetic mean of the price ratios – Carli index The ratio of arithmetic mean prices – Dutot index The geometric mean of the price ratios = the ratio of geometric mean prices – Jevons index

UNECE Statistical Division Slide 7July 2007 Calculation of elementary indices Weighted averages: Laspeyres price index Geometric Laspeyres price index Caution: Explicit weights in Dutot indices may conflict with the implicit weighting by the price level in this type of an index

UNECE Statistical Division Slide 8July 2007 Calculation of elementary indices How to decide which formula to apply? The axiomatic or test approach - focuses on the statistical properties of the index The economic approach - focuses on the economic interpretation of the index

UNECE Statistical Division Slide 9July 2007 Calculation of elementary indices The economic approach to output PPIs Assuming revenue maximizing producers it shows the ratio of Revenues, R, with fixed input and technology, v: R(p t,v)/R(p 0,v) Producers keep fixed relative quantities => Carli or Dutot appropriate Producers keep fixed revenue shares (not very likely!) => Jevons to be preferred Laspeyres and Paasche provides the lower and upper bounds to the economic/theoretical output PPI, under normal conditions

UNECE Statistical Division Slide 10July 2007 Calculation of elementary indices The economic approach to input PPIs Assuming cost minimizing producers, it shows the ratio of costs (C) with fixed output and technology, y: C(p t,y)/C(p 0,y) Producers (purchasers) keep fixed relative input quantities => Carli or Dutot appropriate – not always the case in practice Producers (purchasers) keep fixed input value shares => Jevons to be preferred Paasche and Laspeyres provides the lower and upper bounds to the economic/theoretical input PPI, under normal conditions  However, the assumptions are often not fulfilled in reality => The economic approach does not provide clear answers about what formula to use

UNECE Statistical Division Slide 11July 2007 Calculation of elementary indices Conclusions: Jevons has better statistical properties Don’t give too much weight on the economic approach for elementary indices Jevons or Carli may be used for most elementary indices Dutot should only be used for elementary aggregates that consists of strictly homogenous products A chained Carli should not be used because of build-in upward bias If weights are available, Laspeyres or Geometric Laspeyres indices may be calculated. Be careful to apply weights in Dutot indices

UNECE Statistical Division Slide 12July 2007 Basic measures The prices: Output PPI: The prices received by the producer, i.e. basic prices (SNA) excluding taxes plus subsidies Input PPIs: The price actually paid by the purchaser, including taxes net of subsidies, i.e. purchasers‘ prices Transfer prices Becomes more common as (international) trade is growing and posses serious measurement problems Often they do not reflect real market prices. In such cases: Use estimated or imputed prices, or Exclude the transfer prices from the index

UNECE Statistical Division Slide 13July 2007 Basic measures The coverage of production and establishments: The statistical unit for the PPI is usually the output generating entity, the establishment, as outlined in the SNA However, globalization, outsourcing and the emergence of virtual corporations etc. makes the identification of the statistical unit still more difficult in practice  Be as close as possible to the principle target of the PPI  Coordinate with National Accounts (NA): - NA may provide the weighting data - A main use of PPIs is deflation of NA data Thus, a consistent approach should be aimed at

UNECE Statistical Division Slide 14July 2007 Quality adjustments The pace of innovation is high, leading to continual changes in the quality of products There is not much consistency among countries in the methods they use to deal with quality change Empirical studies indicate that the choice of method can lead to very different results The way in which a product is replaced by another always imply some assumption about the relative qualities of the 2 products – You cannot “do nothing”!

UNECE Statistical Division Slide 15July 2007 Methods for Quality adjustments a)Direct comparison: The price of the new product is compared directly with the price of the old one. Assumption: the 2 are of similar quality and the whole price change is included in the index b)“Link to show no change”: The price of the new item is linked into the index. The price change is assumed to equal the quality change and thus not included in the index calculation c)Overlapping prices: With overlapping prices the new item can be linked into the index. This assumes that the price difference reflects the value of any quality difference between the two items

UNECE Statistical Division Slide 16July 2007 Methods for Quality adjustments d)Matched models only. Only those products for which a price is recorded in both the current and the reference period are included in the calculation of the elementary index. This corresponds to imputation, where the price development of the new product is estimated by the average price development of those product for which matched prices have been recorded e)Option prices: If the difference between A and C 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

UNECE Statistical Division Slide 17July 2007 Methods for Quality adjustments f)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 g)Experts judgement: Persons with detailed product knowledge value the difference between the new and old product, and appropriate adjustment are made in the recorded prices h)Hedonic adjustments by use of hedonic regression. Resource and data demanding

UNECE Statistical Division Slide 18July 2007 A, B and C Methods for QA 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 and numerous practical examples. It is available from Eurostat’s webpage  The Voorburg Group on Services Statistics also provides useful information. Webpage:

UNECE Statistical Division Slide 19July 2007 Unique products Unique products pose a special problem for quality adjustments in PPIs. For example: major equipment projects, special machineries, ships and aircrafts IT, management and other types of business services Telecommunication; tailored equipment and service agreements Transport services => It is not possible to “compare like with like” and the value of possible quality changes is difficult to estimate

UNECE Statistical Division Slide 20July 2007 Unique products – Model pricing Model Pricing: Construct a model by combining a set of components that can be priced over time. The model should be as representative as possible. It does not have to be a project actually produced or sold on the market. The following criteria applies: The model needs regular update to ensure that it continues to be representative The model should be defined in terms of outputs, not inputs The prices used should be the actual charged prices, taking account of profit margins and discounts offered to costumers

UNECE Statistical Division Slide 21July 2007 Unique products – Specification prices Specification Prices: Break down a real product into its key elements. In the successive periods individual projects are examined and the prices of the matched set of elements are compared. No ideal, representative model has to be constructed or updated The following criteria applies: The key elements may become less relevant over time and will need to be updated regularly The key elements should be specified in terms of outputs rather than inputs

UNECE Statistical Division Slide 22July 2007 International prices The use of international price indices is an acceptable (B) method if they can be considered representative of the price development in the country. Examples: - Energy and raw material prices - Computers For example, US compiled hedonic based indices for computers and peripherals available on Internet may be used as a data source, adjusting for exchange rate changes if needed