1. 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

2. 23/10/2015 2 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

3. 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) 23/10/2015 3 Statistics Canada Statistique Canada

4. 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. 23/10/2015 4 Statistics Canada Statistique Canada

5. 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 23/10/2015 5 Statistics Canada Statistique Canada

6. 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. 23/10/2015 6 Statistics Canada Statistique Canada

7. 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. 23/10/2015 7 Statistics Canada Statistique Canada

8. 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.” 23/10/2015 8 Statistics Canada Statistique Canada

9. 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. 23/10/2015 9 Statistics Canada Statistique Canada

10. 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. 23/10/2015 10 Statistics Canada Statistique Canada

11. Quality adjustment methods  Implicit QA methods Direct price comparison Overlap Overall mean imputation Class mean imputation Linked-to-show-no-price- change Matched model 23/10/2015 11 Statistics Canada Statistique Canada  Explicit QA methods Expert valuation Production costs Quantity adjustment Option cost Hedonics

12. Jevons price index formula 23/10/2015 12 Statistics Canada Statistique Canada

13. IMPLICIT QUALITY ADJUSTMENT METHODS 23/10/2015 13 Statistics Canada Statistique Canada

14. 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. 23/10/2015 14 Statistics Canada Statistique Canada

15. 1. Direct price comparison 23/10/2015 15 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 X10015161.067106.7 ITEM Y10022.5251.111111.1 ITEM Z10014 N/A ITEM R (Replacement) 18 1.286128.6 All10016.7819.311.151115.1

16. 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. 23/10/2015 16 Statistics Canada Statistique Canada

17. 2. Overlap method 23/10/2015 17 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.

18. 2. Overlap method 23/10/2015 18 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 X10015161.067106.7 ITEM Y10022.5251.111111.1 ITEM Z10014N/A ITEM R (Replacement) 16181.125112.5 All100 17.54 19.311.101110.1 16.78

19. 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 23/10/2015 19 Statistics Canada Statistique Canada

20. 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. 23/10/2015 20 Statistics Canada Statistique Canada

21. 3. Overall mean imputation 23/10/2015 21 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 X10015161.067106.7 ITEM Y10022.5251.111111.1 ITEM Z10014 15.24 1.089108.9 ITEM R (Replacement) n/a 18 n/a All10016.7818.271.089108.9

22. 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. 23/10/2015 22 Statistics Canada Statistique Canada

23. 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. 23/10/2015 23 Statistics Canada Statistique Canada

24. 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. 23/10/2015 24 Statistics Canada Statistique Canada

25. 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, 23/10/2015 25 Statistics Canada Statistique Canada

26. 4. Class mean imputation 23/10/2015 26 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 X10015161.067106.7 ITEM Y10022.5251.111111.1 ITEM Z10014 15.56 1.111111.1 ITEM R (Replacement) n/a 18 n/a All10016.7818.391.096109.6

27. 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. 23/10/2015 27 Statistics Canada Statistique Canada

28. 5. Matched model 23/10/2015 28 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 X10015161.067106.7171.063113.3 ITEM Y10022.5251.111111.127136.1120.0 ITEM Z10014N/A 1.089 136.1N/A ITEM R (Replacement) 18N/A 136.1 201.111121.0 All10016.7818.391.089108.920.91.084118.0

29. 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. 23/10/2015 29 Statistics Canada Statistique Canada

30. 23/10/2015 30 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 X10015161.067106.7 ITEM Y10022251.111111.1 ITEM Z10014n/a ITEM R (Replacement) 18 1.000100.0 All100 16.78 19.311.058105.8 18.25

31. 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. 23/10/2015 31 Statistics Canada Statistique Canada

32. 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% 23/10/2015 32 Statistics Canada Statistique Canada

33. EXPLICIT QUALITY ADJUSTMENT METHODS 23/10/2015 33 Statistics Canada Statistique Canada

34. Explicit quality adjustment methods  Direct adjustment methods Option price Production cost Expert judgement Hedonics  More resource intensive compared to Implicit methods. 23/10/2015 34 Statistics Canada Statistique Canada

35. 1. Direct adjustment 23/10/2015 35 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 X10015161.067106.7 ITEM Y10022.5251.111111.1 ITEM Z10014 N/A ITEM R (Replacement) 17 18 1.059105.9 All10016.7819.311.079107.9 Value of the quality difference is $3

36. 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. 23/10/2015 36 Statistics Canada Statistique Canada

37. The model and parameter estimates 23/10/2015 37 Statistics Canada Statistique Canada

38. Hedonics: assumptions  Product characteristics must be quantifiable.  The collection of relevant product characteristics does not change. 23/10/2015 38 Statistics Canada Statistique Canada

39. Hedonics: issues  Functional form  Multicollinearity  Sample size  Coefficients need to be stable 23/10/2015 39 Statistics Canada Statistique Canada

40. 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. 23/10/2015 40 Statistics Canada Statistique Canada

41. 23/10/2015 41 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

42. Clothing: the Canadian practice 23/10/2015 42 Statistics Canada Statistique Canada

43. 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. 23/10/2015 43 Statistics Canada Statistique Canada

44. Clothing 23/10/2015 44 Statistics Canada Statistique Canada

45. Monthly clothing indexes. Jan 2001 to Sept 2009 23/10/2015 45 Statistics Canada Statistique Canada

46. Monthly clothing indexes. Jan 2001 to Sept 2009 23/10/2015 46 Statistics Canada Statistique Canada

47. 23/10/2015 47 Statistics Canada Statistique Canada

48. 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, 2007 23/10/2015 48 Statistics Canada Statistique Canada

49. 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 23/10/2015 49 Statistics Canada Statistique Canada

50. 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. 23/10/2015 50 Statistics Canada Statistique Canada

51. 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 : 20020106 23/10/2015 51 Statistics Canada Statistique Canada

52. 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 23/10/2015 52 Statistics Canada Statistique Canada Back yoke Long sleeves with single cuffs No trim Good workmanship Safety stitch seams Perma-press finish 6 pearlized buttons

53. 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 23/10/2015 53 Statistics Canada Statistique Canada

54. 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 23/10/2015 54 Statistics Canada Statistique Canada

55. 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. 23/10/2015 55 Statistics Canada Statistique Canada

56. Clothing: the Canadian practice 23/10/2015 56 Statistics Canada Statistique Canada

57. Clothing: the Canadian practice 23/10/2015 57 Statistics Canada Statistique Canada

58. Clothing: the Canadian practice 23/10/2015 58 Statistics Canada Statistique Canada

59. Clothing: the Canadian practice 23/10/2015 59 Statistics Canada Statistique Canada

60. Clothing: the Canadian practice 23/10/2015 60 Statistics Canada Statistique Canada

61. Clothing: the Canadian practice 23/10/2015 61 Statistics Canada Statistique Canada

62. 23/10/2015 62 Statistics Canada Statistique Canada

63. 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. 23/10/2015 63 Statistics Canada Statistique Canada

64. Clothing and hedonics (CDA) 23/10/2015 64 Statistics Canada Statistique Canada

65. Clothing and hedonics (CDA) 23/10/2015 65 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.

66. Clothing and hedonics (CDA) 23/10/2015 66 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.

67. Final thoughts about clothing  The issue of fashion  Should sale prices be used?  Dutch approach: seasonal baskets  Hedonics 23/10/2015 67 Statistics Canada Statistique Canada

68. The end 23/10/2015 68 Statistics Canada Statistique Canada