1. 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

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

3. 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!

4. 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?

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

6. 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”!

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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:

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 3. Useful links
CPI Manual in English and Russian is available from
Supplementary Handbook: Practical Guide to Compiling Consumer Price Indices. Available on
Handbook on price and volume measures in national accounts. Available from Eurostat website
Papers from Joint UNECE/ILO Meetings on CPI are available on
Papers from meetings in the Ottawa Group on Price Indices are available from
The Voorburg Group on Services Statistics provides useful information on

31. 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