Producer Price Index Manual: Theory and Practice ... - METAC

7. Treatment of Quality Change
other in its first. Further, the technical differences
between the products are likely to be of an order
that makes it more difficult to provide reliable, explicit
estimates of the effect of quality differences
on prices under approach 4. By implication, many
of the methods of dealing with quality adjustment
for unavailable products will work better if the
switch to a replacement product is made sooner
rather than later. Sampling issues thus are closely
linked to quality adjustment methods. This will be
taken up in Chapter 8, in the section on product selection
and the need for an integrated approach to
dealing with both representativity and qualityadjusted
prices.
A.2.3 New products
7.27 The third potential source of error is distinguishing
between new products and quality
changes in old ones, also covered in Chapter 8.
When a truly new product is introduced, there are
at least two reasons why early sales are at high
prices that later fall, often precipitously: capacity
limitations and market imperfections. Both of
these may be present shortly after introduction of a
new product because there or are few suppliers for
it.
7.28 Early in the product life cycle, production
processes may have limited capacity; therefore,
producers find themselves operating at relatively
high and increasing marginal costs of production.
Marginal costs of operation tend to decline as more
producers enter the market or as existing producers
redesign and upgrade production facilities for
higher volume. Both of these bring operating levels
back from high marginal cost, near full capacity
levels.
7.29 With or without early capacity constraints,
the small number of suppliers early in the life cycle
allows what economists call market imperfections
to arise. In an imperfectly competitive market,
the producer can charge a monopoly price
higher than the marginal cost of production. As
more competitors enter the market for the new
good or service, the monopoly power of early sellers
decreases and the price tends to drop toward
marginal cost. For example, the introduction of the
zipper closure for clothing was a completely new
good that led to an initial gain to zipper producers
who could extract an additional surplus from the
purchasers (clothing manufacturers). As other zipper
suppliers entered the market, the price fell.
7.30 The initially high price at introduction and
its full subsequent decline would not be brought
into the index fully by the usual methods. Compilers
commonly either wait until the index is rebased
or until a product in the sample becomes unavailable
to seek a replacement product and admit the
possibility of detecting a new good. After capacity
constraints or monopoly profits diminish, subsequent
price changes may show little difference
from other broadly similar products. Standard approaches
thus wait too long to pick up these early
downtrends in the prices of new goods.
7.31 At the extreme, capturing the initial price
decline requires a comparison between the first observed
price and a hypothetical price for the period
before its introduction. The hypothetical price
would be the price below which there would be no
positive market equilibrium quantity bought and
sold. 3 Again, frequent resampling offers the possibility
of catching new goods early in the product
cycle when their prices are high and market share
relatively low, thereby capturing early price declines
as producers relieve capacity constraints and
new entrants compete market imperfections away.
7.32 Finally, it is important to emphasize that
there is not only a price decline but also a market
share increase in the stylized product life cycle.
Frequent resampling and focused scanning for new
products should be at least somewhat effective in
capturing the price declines in early product cycles.
Compilers face a potentially serious problem,
however, if they have no market share information
to go with the prices. The stylized facts of the
product cycle are that a new product comes in at a
high price and a low market share. The price then
declines and market share increases. Both prices
and market share then stabilize for a period, until a
3 This hypothetical price differs from the reservation
price, the other conceptual solution to the problem of new
goods offered, for example, by Hicks (1940) and Fisher and
Shell (1972). For a CPI, this preceding price is the highest
notional price at which the quantity demanded would have
been zero. The user’s reservation price thus will be higher
than the first observed price. For a PPI, the comparison
would be between the price in the period of introduction
and the lowest notional price in the preceding period at
which the quantity supplied would have been zero. The
supplier’s reservation price will be lower than the first observed
price. The product life cycle is based on the typical
track of the market equilibrium price and market share, on
both the technical possibilities of suppliers and the preferences
of users, rather than one to the exclusion of the other.
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