Academic journal article Federal Reserve Bank of New York Economic Policy Review

Price Hedonics: A Critical Review

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Price Hedonics: A Critical Review

Article excerpt

1. INTRODUCTION

Price hedonics is a statistical technique developed more than seventy years ago to assess product quality issues. It had enjoyed a quiet and respectable life since coming of age in the early 1960s, but in the past few years, it has gained a degree of notoriety through a series of highly visible assessments of the consumer price index (CPI). This attention prompted a reassessment of price hedonics and its role in the CPI, which in turn has led to important new dimensions in the study of price hedonics. This paper focuses on these developments.

The new debate began in early 1995, when Federal Reserve Chairman Alan Greenspan testified before the Senate Finance Committee that he thought that the CPI was biased upward by perhaps 0.5 to 1.5 percentage points per year. This remark did not surprise specialists who understood the technical difficulties involved in constructing accurate price indexes, but it created a small sensation in the political arena. Here at last was a chance to get around one of the most difficult issues in the debate over balancing the federal budget: what to do about the social security program. Here was a way to reduce expenditures to balance the federal budget and rescue the social security trust fund from insolvency in the next century.

The beauty of it all was that the solution did not involve raising new taxes or changing benefit formulas. Instead, the solution involved "fixing" a biased method of adjusting social security benefits for the effects of price inflation, that is, by fixing the way the U.S. Department of Labor's Bureau of Labor Statistics (BLS) handles problems such as those posed when a new, improved product appears on the market.

These political considerations may seem tangential to the subject of price hedonics, but the events following from Greenspan's remark have linked the two issues. First, the Senate Finance Committee consulted a panel of experts, and that panel reached a consensus supporting Greenspan's estimate. Congress subsequently established the Advisory Commission to Study the Consumer Price Index (better known as the Boskin Commission, after its chairman) to estimate the level of the CPI bias. Boskin et al. (1996) arrived at an estimated bias of 1.1 percentage points per year--a level almost identical to Greenspan's estimate. Furthermore, the report said that about half (0.6) of that bias could be attributed to product innovations that were being overlooked in the CPI. A parallel study by Shapiro and Wilcox (1996) came to the same conclusion, estimating an overall bias of 1 percentage point per year, with 0.45 of that bias coming from quality changes and new goods. The study also observed that this bias was the most difficult to correct, likening the quality-adjustment process to house-to-house combat.

Price hedonics enters this picture because it offers the best hope for dealing with the bias that comes from product innovation. Although Boskin et al. (1996) did not explicitly recommend that the BLS expand the use of this technique in the CPI program (as a report by Stigler [1961] did), the BLS moved in this direction by increasing the number of items in the CPI treated with price hedonic techniques. In 1998, the BLS also requested that the Committee on National Statistics of the National Research Council (NRC) set up a panel of experts to investigate the conceptual issues involved in developing a cost-of-living index, including the use of price hedonic methods. This committee, chaired by Charles Schultze, released its report in early 2002 (National Research Council 2002). The NRC panel did not provide unanimous support for the underlying philosophy of the CPI as a pure cost-of-living index, and, in its own words, differs from the Stigler and Boskin et al. reports in this regard (National Research Council 2002, p. 3).

The NRC panel was cool to the BLS's expanded commitment to price hedonics. On the one hand, the NRC report endorsed hedonic techniques as a research tool, commenting that they "currently offered the most promising approach for explicitly adjusting observed prices to account for changing product quality. …

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