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

Producer Price Index Manual
the revenue from one unit of the replacement is the
same as one unit of the original, then the price of
the replacement, after adjusting for the change in
quality, is only 2/3 that of the price of the original.
If one unit of the replacement sells for twice the
price of the original, then the quality adjusted price
is (2 × 2/3 =) 4/3 that of the original: the price increase
is 33 percent, not 100 percent. The PPI seeks
to record the change between the price of the original
and the quality-adjusted price of the replacement.
1.216 Of course, it is difficult to estimate the
quality adjustment in practice, but the first step has
to be to clarify conceptually the nature of the adjustment
that is required in principle. In practice,
producers often treat the introduction of a new quality,
or new model, as a convenient opportunity in
which to make a significant price change. They may
deliberately make it difficult for purchasers to disentangle
how much of the observed difference in
price between the old and the new qualities represents
a price change.
1.217 For PPI purposes, an explicit quality adjustment
is often possible using differences in the
costs of production between the two qualities. This
approach works as long as production costs are
based on the establishment using the same technology.
Another alternative is to make an implicit adjustment
by making an assumption about the pure
price change: for example, on the basis of price
movements observed for other products. The discussion
below examines the implicit methods first
and then the explicit methods. These approaches are
examined in some detail in Sections D and E of
Chapter 7.
1.218 When the technology changes, there is no
comparable basis for comparing costs between the
two qualities, and these procedures break down. An
alternative approach would be to use hedonic regression
techniques, which are also discussed below
and in more detail in Section G of Chapter 7.
M.2 Implicit methods
M.2.1 Over-lapping qualities
1.219 Suppose that the two qualities overlap,
both being produced at time t. If both are produced
and sold in a competitive market, economic theory
suggests that the ratio of the prices of the new to the
old quality should reflect their relative cost to producers
and value to purchasers. This implies that
the difference in price between the old and the new
qualities does not indicate any change in price. The
price changes up to period t can be measured by
the prices for the old quality, while the price
changes from period t onwards can be measured by
the prices for the new quality. The two series of
price changes are linked in period t, the difference
in price between the two qualities not having any
impact on the linked series.
1.220 When there is an overlap, simple linking of
this kind may provide an acceptable solution to the
problem of dealing with quality change. In practice,
however, this method is not used very extensively
to deal with noncomparable replacements because
the requisite data are seldom available. Moreover,
the conditions may not be consistent with those assumed
in the theory. Even when there is an overlap,
the market may not have had time to adjust, particularly
when there is a substantial change in quality.
When the new quality first appears, the market is liable
to remain in disequilibrium for some time. The
producers of new qualities may price strategically
over the product life cycle to, for example, pricediscriminate
in the early periods following introduction.
There is a case in which the overlap
method is used extensively in spite of these difficulties:
when the index is rebased or products are rotated.
The advantage of refreshing the sample is
deemed to outweigh such disadvantages.
1.221 There may be a succession of periods in
which the two qualities overlap before the old quality
finally disappears from the market. If the market
is temporarily out of equilibrium, the relative prices
of the two qualities may change significantly over
time, so that the market offers alternative evaluations
of the relative qualities depending on which
period is chosen. When new qualities that embody
major new improvements appear on the market for
the first time, it may be that their prices fall relatively
to older qualities, before the latter eventually
disappear. In general, if the price series for the old
and new qualities are linked in a single period, the
choice of period can have a substantial effect on the
overall change in the linked series.
1.222 The statistician has then to make a deliberate
judgment about the period in which the relative
prices appear to give the best representation of the
relative qualities. In this situation, it may be preferable
to use a more complex linking procedure that
uses the prices for both the new and the old quali-
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