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

21. Quality Change and Hedonics
This applies to all econometric models, but it is
particularly relevant to hedonic models; on this
point see Wooldridge (1996, 400–01) in particular.
The equilibrium conditions for characteristic prices
imply functional relationships among the characteristics
of demanders, suppliers, and products.
This in turn reduces the likelihood that important
excluded variables will be uncorrelated with the
included variables of the model (see also Bartik,
1988, on this point). The bias arises because buyers
are differentiated by characteristics (y,α) and
sellers by technologies τ . The type of item buyers
will purchase is related to (y,α) and the type sellers
provide to τ . On the plane of combinations of z
transacted, the equilibrium ones chosen may be
systematically related; the characteristics of buyers
are related to those of sellers. Epple (1987) uses
the example of stereo equipment: the higher income
of some buyers leads to purchases of highquality
equipment and the technical competence of
sellers leads them to provide it. The consumer and
producer characteristics may be correlated.
21.80 Wooldridge (1996, pp. 400–01) suggests
that individual consumer and firm characteristics
such as income, education, and input prices should
be used as instruments in estimating hedonic functions.
In addition, variables other than a good’s
characteristics should be included as instruments if
they are price determining, such as geographical
location—say proximity to ports, good road systems,
climate, and so on. Communities of economic
agents are assumed, within which consumers
consume and producers produce for each other
at prices that vary across communities for identical
goods. Variables on the characteristics of the
communities will not in themselves enter the demand
and supply equation but are price determining
for observed prices recorded across communities.
Tauchen and Witte (2001) provide a systematic
investigation of the conditions under which
consumer and producer and community characteristics
will affect the hedonic parameter estimates
for a single-regression equation estimated across
all communities. A key concern is whether the hedonic
price function error term represents factors
that are unobserved by both the economic agents
and the researcher, or by the researcher only. In the
latter case the error term may be correlated with
the product attributes and instrumental variable estimation
is required. If the error term is not correlated
with the product characteristics—preferences
are quasi-linear—then a properly specified hedonic
regression, including community-specific characteristics
or appropriate slope dummies, can be estimated
using OLS. In other cases, depending on
the correlation between consume and producer
characteristics, assumptions about the error term
and the method of incorporating community characteristics
into the regression, instrumental variables,
including consumer or producer or community
dummy or characteristics, may need to be
used.
Functional form
21.81 Triplett (1987; 2002) argues that neither
classical utility theory nor production theory can
specify the functional form of the hedonic function.
29 This point dates back to Rosen (1974, p. 54)
who describes the observations as being “..a jointenvelope
function and cannot by themselves identify
the structure of consumer preferences and producer
technologies that generate them.” A priori
judgments about what the form should look like
may be based on ideas about how consumers and
production technologies respond to price changes.
These judgments are difficult to make when the
observations are jointly determined by demand and
supply factors but not impossible in rare instances.
However, it is complicated when pricing is with a
markup, the extent of which may vary over the life
cycle of a product. Some tied combinations of
characteristics will have higher markups than others.
New item introductions are likely to be attracted
to these areas of characteristic space, and
this will have the effect of increasing supply and
thus, lowering the markup and price (Cockburn
and Anis, 1998; Feenstra, 1995, p. 647; and
Triplett, 1987, p. 38). This again must be taken
into account in any a priori reasoning—not an easy
or straightforward matter.
21.82 It may be that in some cases the hedonic
function’s functional form will be very straightforward.
For example, prices on the websites for
options for products are often additive. The underlying
cost and utility structure are unlikely to
jointly generate such linear functions, but the producer
or consumer are also paying for the conven-
29 Arguea, Hsiao, and Taylor (1994) propose a linear form
on the basis of arbitrage for characteristics, held to be likely
in competitive markets, although Triplett (2002) argues that
this is unlikely to be a realistic scenario in most commodity
markets.
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