Academic journal article Review - Federal Reserve Bank of St. Louis

Commentary: Charles Hulten

Academic journal article Review - Federal Reserve Bank of St. Louis

Commentary: Charles Hulten

Article excerpt

The content of Charles R. Hulten's article, "Quality Change in the CPI: The Neglected Cost Dimension," has two main components. First, it presents an overview of the methods and problems associated with quality measurement in the consumer price index (CPI). Second, the article discusses two "new" biases, one that involves the "cost side" of producing new goods, and one that focuses on the specific practice of "linking" and the possibility that linking may overstate the extent of quality increases. My discussion focuses on the new biases and on some general issues about quality change that are of particular interest to macroeconomists.

THE LINK BIAS

The link method is the "least informed" method. It relies on price comparisons among goods that are not close substitutes to the given good. Hulten points out that, in practice, linking leads to large quality adjustments: Of the total price increases for these goods, 86 percent are assigned to quality improvements in 1984. In contrast, goods for which better adjustment methods are available only have 22 percent of their total price increases assigned to quality improvements. This difference is striking, and I agree with Hulten's suspicion. He estimates the magnitude of this bias by hypothetically reducing the quality component of the price change in these link-method items from 86 percent to 22 percent. The implied bias is -0.73 of a percentage point for the aggregate CPI. This is a useful exercise, but more work is clearly needed to obtain sharper estimates. For example, the reason better methods may have not been used for many of the link-method items is precisely that these items have embodied substantial quality change. Hence, Hulten's bias estimate should perhaps be interpreted as more of an upper bound than as a point estimate.

When large differences in quality adjustments occur across groups of goods, then relatively small changes in the composition of goods-in this case, say, a change in the relative size of the group of goods for which linking is used-may lead to large changes in the overall price index. Such changes could occur because of accounting practices (the assignment of goods to the different methods of price measurement) or simply because goods with substantial quality change are increasing in importance in the economy. As I will argue, this phenomenon could lead to significant changes in measured aggregate productivity growth.

THE COST SIDE

New qualities are usually produced at a cost, and Hulten explains how a second new bias might arise as a result. This cost could take the form of more expensive materials or resources associated with developing the new product and that appear as a markup. A parameter , in Hulten's article captures the fraction of the percentage quality increase in the product that has a corresponding cost increase. (If the quality goes up by 1 percent, the cost of producing it goes up by (mu) percent.) Hulten calls for an upward adjustment of quality in inverse proportion to ,tu (i.e., for a downward price adjustment). Given this view, he suggests a revision of the official price index that is based on estimation of (mu) in another article (Hulten 1996).

A simple example should clarify the issues. Suppose computers are identified with one characteristic-speed of computation-and computers of different speeds are perfect substitutes (and divisible). For simplicity, suppose also that there is no "pure price" change (the dollar price of the same good stays the same over time, if the good is traded). Now imagine that from one year to the next a new computer (Y) is developed. The new computer is better (faster) than the old, baseline computer (X) by a factor 0. Denote the price of the new computer at t+1 by P sub Y (t+l), and let the baseline computer in year t have been priced at P sub X (t). Hulten states that P sub Y (t+1) = (1+(mu) Theta) P sub X (t), where (mu) is the fraction of the percentage increase in quality that also increases costs. …

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