Adjusting for Quality Change

7.1 The measurement of changes in the level of consumer prices is complicated by the appearance and disappearance of new and old goods and services, as well as changes in the quality of existing ones. If there were no such complications, then a representative sample could be taken of the items households consume in period 0, their prices recorded and compared with the prices of the same matched items in subsequent periods, say t. In this way the prices of like would be compared with like. However, such complications do exist. For example, an item may no longer be produced in period t+1, so its price comparison cannot be undertaken between periods 0 and t+1. 7.2 A number of methods are available to remedy this. A replacement item may exist in period t+1. If it is of the same quality, its price can be compared with the ‘‘old’’ item’s price in period t. But the replacement item may well be of a different quality. One option is to ignore the quality difference and continue comparing the price of the ‘‘new’’ replacement item in t+1with that of the old one in period t to continue the series. An adjustment for the difference in quality is still being made; it is just that it is a very poor adjustment, because the change in quality has no effect on the price. A second option is to exclude from the index those items for which quality changes, and to compile the index link between t and t+1 only for matched items having characteristics that are the same. This exclusion amounts to an implicit quality adjustment, one that assumes the overall price change of existing matched items will be the same as the qualityadjusted price change between the missing old and replacement new items. In reality, however, price changes generally vary over the stages of a product’s life cycle. Price changes at the time of, say, a model’s upgrade – when an item is missing and replaced – may be quite different from those at other stages. The implicit assumption may therefore be inappropriate. Third, the price change of a new replacement item may be spliced onto the index if the prices of the disappearing and replacement items are available in a common overlap period, say period t. The old item’s price change between periods 0 and t is multiplied by the replacement item’s price change between periods t and t+1. Yet again, there is an implicit quality adjustment, one that requires the price difference between the old item and its replacement in period t to reflect the effect of the quality difference on price. Such differences may also be in part the result of strategic price-setting behaviour related to the period in the item’s life cycle. 7.3 There are other methods of adjusting the prices of non-comparable replacements for quality differences, including ones that use explicit estimates of the effect of the quality change on price. There are a number of methods of deriving such explicit estimates, and the suitability of explicit quality adjustments depends as much on the method used as on the availability of appropriate data to implement the method. In each case, whatever procedure a statistical office follows, a quality adjustment to prices is made in every period when an item is not available. The purpose of this chapter is to help ensure that these quality adjustments are the appropriate ones. 7.4 There are three main reasons for considering how to adjust for quality change. First, the scale and pace of methodological innovations are substantial. Second, there is a lack of consistency in the methods chosen by statistical offices for dealing with quality changes; thus comparisons of consumer price indices between product areas, across countries, and over time may be misleading. Finally, a number of empirical studies on the effects of using different methods found that choice of method does indeed matter (Dulberger, 1989; Armknecht and Weyback, 1989; Moulton andMoses, 1997; Lowe, 1996). 7.5 Against these concerns, it must be recognized that statistical agencies do guard against quality changes by using the matched models method. Price collectors record the features of selected items and collect prices for the very same models in subsequent periods in order to compare like with like. If a product group exists in which there are no items whose quality changes and no new or disappearing goods and services, then the matched models method based on representative items works. More generally, three potential sources of error arise from the matched models approach: missing items, sample space change, and new products.