Price Indexes (11) Deflating Output Measures

Economists are often concerned about the impact that quality adjustment or hedonic adjustment might have on the measurement of real GDP. Given a certain nominal GDP (in dollars or any other currency unit), the number for the price deflator determines the size of real GDP and its real growth rate. If the measured inflation rate is low, the real GDP will be higher and vice versa, and along with that one also gets higher or lower numbers for productivity changes.

This statement is correct, but misses an important point. When applying a deflator, if improvements in quality are not adjusted in the deflator, they will not appear in real output measure. The best way to explain this is to consider a Ford factory that produced a million Model T Fords in 1920. The same factory is now producing a million Ford Mustangs. Say the price of Model T was $300 and the price of a Ford Mustang is now $30,000, the value of the output of the factory has increased from $300 million to $30 billion. However, the price index of these cars has risen one hundredfold.

If this price index is used as a deflator without any quality adjustment, the real value of the output of the factory will be.

30b/300m*300/30000 = 1

This result indicates that the output of the factory has not changed. If the number of people working at the factory was the same, no increase in productivity would be recorded. Most people would find these results hard to accept and claim that developing a Mustang took a lot of research and development and provides greater utility to the car owner. Although the factory is still producing a million cars, it is producing better quality cars.

The reason that output does not change is that all the quality improvements were captured in the price index. Although part of the increase in price from 300 to 30,000 is the result of an improvement in quality, no adjustment was made to the price index. Because all the quality improvement was captured in the price index, it is excluded from the resultant measure of real output.

The only way to feed to quality improvement into the real output measure is to quality adjust the price index. If it is assumed that a Ford Mustang is ten times better than a Tin Lizzie, the price index will show a only tenfold increase (rather than the hundredfold used above). The factory will now show a tenfold increase in real output. This is a more sensible result.

A good way to make this clear is to think about a Russian factory that was producing a million Ladas and a United States factory that was producing a million Ford Mustangs. Is their output equivalent? I suspect that most Americans would think that the American factory had greater output. The difference is a difference in quality.

So in general we expect improvements in the quality of products to be included in measures of real output and real GDP. But as already shown, this can only happen, if a quality-adjusted price deflator is used. It follows that if the quality adjustment in the price index is biased then the resultant measure of real GDP will be biased.

If the measured inflation rate is not adjusted for quality change, the real GDP will be too low, and along with that one also gets lower numbers for productivity changes.
Much of the drive for improving the methods of quality assessment used in price indexes has come from National Accountants who want better deflators for their estimates of GDP.