Sunday, March 21, 2010

Price Indexes (10) Quality Adjustment

Some will say that the problem is with quality adjustment, full stop. They argue that the problem is not with the hedonic method, but with all quality adjustments, however they are made. To answer their concerns, I will explain why quality adjustment is necessary. The best way is to look at some examples. These will show that the adjustments made by statisticians actually reflect the way that consumers think when they are making purchases.

The most basic form of quality adjustment is an adjustment for a change in “quantity”. A good example is breakfast cereal. A common trick for cereal manufacturers is to keep both the size of the cereal carton and the price unchanged, but reduce the weight of cereal in the box. Many consumers will not notice, but the astute consumer will consider that the price of the cereal has increased. Some people take a calculator to the supermarket, so that they can get the best deal calculating the price per kilogram. The statistician makes a similar adjustment to the price to allow for the change in volume. If this were not done, the index would not record increases in cereal prices.

Now consider a more difficult example. Suppose a manufacturer of muesli or granola leaves the dimension of the package, the weight of cereal and the price unchanged, but changes the recipe by putting in less high quality grains and replacing them with low grade flour. Some consumers might not notice the difference, but those who do will choose a different product, because they think that the value for money has changed. The price of the granola is unchanged, but the consumer is getting a different product. In practice, these small changes might be impossible to measure, but the principle the statistician should make an adjustment to the price to reflect the change in quality.

These two examples show that the quality assessments made by price statisticians are similar to those make by consumers deciding which product to purchase. With other products the process may be more complicated, but the question is still the same: What value does the change have to consumers? Quality adjustment reflects the behaviour of consumers.

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