The Consumer Price Index

Transcription

1 Mark A. Wynne Senor Economst Fona D. Sgalla Assocate Economst The Consumer Prce Index T Wthout the noton of prce there would be no economc scence. The concept s of absolutely central sgnfcance. It s not as easy and trval a concept as t appears to be at frst sght. A satsfactory measurement of prce s, as a consequence, a dffcult undertakng, and t s not surprsng that prce statstcs, abundant as they are, have to be approached wth utmost cauton. Oskar Morgenstern On the Accuracy of Economc Observatons he consumer prce ndex (CPI) s one of the most closely watched prce statstcs publshed by the federal government. As an ndcator of nflatonary trends n the U.S. economy, the monthly CPI report undergoes ntense scrutny. For example, an upsurge n the rate of ncrease n the CPI n early 1993 prompted the Federal Reserve to lean toward rasng nterest rates n ts polcy delberatons. When the nflatonary surge proved short-lved, the Fed reverted to a neutral stance. 1 Movements n the CPI also have a drect mpact on the pocketbooks of many Amercans. For nstance, the annual ncrease n the CPI determnes the rate at whch the nomnal payments to Socal Securty recpents wll rse each year. The tax brackets that determne the ncome tax lablty of most workers are ndexed to the CPI as well. In ths artcle, we revew the constructon of the CPI and dscuss ts potental shortcomngs. We also examne how well the CPI measures what t s supposed to measure, namely, changes n the cost of lvng. Our prmary objectve s to revew and put nto context what s known about the potental bases n the CPI. Inherent n the concept of bas s some noton of the true value of the CPI, whch the actual publshed value only approxmates. The true value of the CPI s consdered to be the true cost-of-lvng ndex, and so we begn wth a dscusson of the theory of the cost of lvng ndex. We progress to the constructon of the actual CPI as t s reported every month, followng the descrpton of methodology n the Bureau of Labor Statstcs (BLS) Handbook of Methods. In the remander of the artcle, we consder how well the CPI approxmates the true cost-of-lvng ndex, payng partcular attenton to the problems of substtuton, qualty change, and the ntroducton of new goods, whch are generally consdered to cause the CPI to overstate the rate of ncrease n the cost of lvng or, alternatvely, overstate the rate of nflaton. 2 Some analysts have suggested that these measurement errors are so large that We are grateful to Marshall Rensdorf and Jack Trplett for detaled comments on ths artcle. We also receved helpful comments from Evan Koeng, Marlyn Manser, Steven Braun, Ken Emery, and Zsolt Becs. Ths artcle s based on a longer paper, enttled A Survey of Measurement Bases n Prce Indexes ( Research Paper no. 9340), that was prepared for the Jont Meetng of the System Commttees on Busness and Fnancal Analyss at the Board of Governors of the Federal Reserve System n Washngton, D.C., September 22 24, We thank our dscussant at that conference, Ana Azcorbe, for comments on that paper. 1 Note that some of ths ncrease has snce been revsed away as a result of changes n the seasonal adjustment factors used to calculate the seasonally adjusted CPI. We do not revew CPI seasonal adjustment procedures n ths paper. 2 These problems wth the CPI are common to almost all offcal prce ndexes and have mplcatons that extend beyond the measurement of nflaton to such ssues as the measurement of real output growth and productvty. Economc Revew Second Quarter

2 CPI nflaton n the 3 to 4 percent range consttutes effectve prce stablty. We argue that there s lttle evdence to support ths belef and that, nsofar as the CPI does overstate the rate of nflaton, t probably does so by no more than 1 percent annually. The conceptual bass of the CPI The conceptual bass of the CPI s the theory of the cost-of-lvng ndex. 3 The cost of lvng s a unque concept for each ndvdual and s determned by the ndvdual s preferences for dfferent types of goods and servces and the prces at whch that person can purchase them. We can thnk of the preferences of each ndvdual as beng characterzed by an ntertemporal utlty functon that s defned over all the goods and servces consumed today as well as all the goods and servces the ndvdual expects to consume n the future. The most general specfcaton of ths functon ncludes tems that have a prce attached to them, such as automobles, harcuts, and bananas, and tems that are typcally consumed wthout a user charge, such as roads, clean ar, and lesure. Specfcally, we can wrte j j ( ) U = U ( q, q,, q, q, q,, q, ) U ( q), M where q t denotes the quantty of the th good or servce consumed at date t. Calculatng a cost-of-lvng ndex requres that all tems n the utlty functon be assgned a prce. Ths task s relatvely straghtforward for commodtes and servces that have a user charge for consumpton (meanng, they are purchased on markets) but s more dffcult for tems such as lesure and clean ar that are typcally consumed wthout a user charge. It s also dffcult for durable goods such as houses and cars, whch are typcally purchased n one perod but yeld servces to the consumer over several perods For a general revew of the theory of the cost-of-lvng ndex, see Pollak (1989). For a dscusson of the theory of the costof-lvng ndex as the conceptual bass for the CPI, see Gllngham (1974). M Because t s mpossble to ascertan the prce of every sngle good and servce that s valued by consumers, the theory of the cost-of-lvng ndex as t s appled to the measurement of consumer prces typcally focuses on a narrower set of goods and servces, specfcally, those that are purchased on markets n some tme perod. Focusng attenton on ths narrower set of goods and servces, whch we wll denote as x t (q 1t,q 2t,,q Nt ), where N < M, we can defne a cost or expendture functon for the ndvdual as follows: ( 2) e( p t t t t, u) = mn p q : U( q ) u, q t N = 1 where p t = (p 1t,p 2t,,p Nt ). The expendture functon gves the mnmum cost to the ndvdual of attanng some specfed level of utlty, u, when faced wth a set of prces, p t, for the goods and servces that enter that person s utlty functon. The true cost-of-lvng ndex s then defned on the bass of the expendture functon. Specfcally, t s the change n the cost of attanng some base level of utlty, u b, between a reference perod, r, and a comparson perod, c: c b (, ) ( 3 e p u ) e( p, u ), r b where p c and p r denote the prces faced by the ndvdual n the comparson and reference perods, respectvely. If all prces n the comparson perod, p c, are twce the reference prces, the ndex s 2; f all prces n the comparson perod are one-half the reference perod prces, the ndex s 0.5. If all prces n the comparson perod are the same as prces n the reference perod, the ndex s 1. The CPI s an approxmaton of ths true cost-of-lvng ndex. How the CPI s constructed The purpose of the CPI s to measure the rate of change n the cost of lvng for urban consumers. It does ths by calculatng the average change n the prces pad by urban consumers for a fxed market basket of goods and servces of constant qualty. Snce t s obvously mpossble to obtan prce data for all consumer transactons n the Unted States, the CPI s estmated from a

3 seres of samples. These samples are desgned wth the objectve of makng the CPI representatve of the prces pad by consumers n all U.S. urban areas for all goods and servces. The use of a sample, of course, ntroduces a source of error nto the ndex, but ths s more than offset by the errors that samplng elmnates. 4 Each year, the BLS selects new tem and outlet samples for 20 percent of the prmary samplng unts on a rotatng bass, wth the ntenton of capturng new developments n the market for consumer goods through such rotaton. Indvdual commodtes n the CPI are weghted by the share of expendture on the tem, as estmated n the Consumer Expendture Survey. The outlets from whch prce quotes are obtaned are determned on the bass of nformaton collected n the Contnung Pont-of-Purchase Survey, wth an outlet s probablty of selecton beng proportonal to ts share of consumers expendture for the good n queston. Currently, the CPI s constructed usng expendture shares obtaned from the Consumer Expendture Surveys and s formally defned as t ( 4) CPI = 100 = 100 = 100 t px b r px b t p r p t p b, r ω p r b px r px where p t,s the prce of the th good n the comparson perod, t, p r s the prce of the same good b n the reference perod, r, x s the quantty of the good consumed n the expendture base perod, r b b px b, and ω = s the share of the th good r b px n base perod expendtures valued at reference perod prces. When the expendture base and the reference perods concde, the result s the standard Laspeyres prce ndex formula. 5 Note that, n general, there s a dfference between the base perod for the expendture weghts and the numerc reference base perod, although at present both are = 100. Indexes are estmated for wage b earners and clercal workers (CPI W) and all urban consumers (CPI U). The CPI W s representatve of the buyng habts of about 32 percent of the U.S. populaton, whle the CPI U (whch was ntroduced n 1978) covers about 80 percent of the U.S. populaton. The prces used to calculate the CPI are collected from about 21,000 retal and servce establshments n eghty-fve urban areas across the Unted States. Data on rents are collected from about 40,000 landlords or tenants, and 20,000 owner-occupants are asked about ther housng unts. All prce nformaton s collected by Bureau of Labor Statstcs feld agents through vsts or telephone calls. The CPI s publshed monthly, typcally about two weeks after the end of the month to whch t refers. The problems that are typcally thought to bas the CPI as a measure of nflaton or the cost of lvng are substtuton bas, qualty adjustment bas, and new goods bas. The sample of goods and servces that makes up the CPI s also crtczed occasonally for beng unrepresentatve of the buyng habts of all urban consumers. Substtuton bas and new goods bas are aspects of ths samplng problem, as s outlet substtuton bas. The problems that arse from the use of lst rather than transactons prces n constructng an ndex are less frequently dscussed n relaton to the CPI than they are n relaton to the producer prce ndex. 6 We argue that the lst transactons problem s probably an ssue n consumer prce measurement, although for dfferent reasons than n producer prce measurement. 4 For estmates of the standard error of the CPI, see Leaver (1992). 5 A Laspeyres prce ndex calculates the prce change between two perods by comparng the cost of purchasng n each perod the bundle of goods purchased n the ntal perod. A Paasche prce ndex calculates the prce change between two perods by comparng the cost of purchasng n each perod the bundle of goods purchased n the fnal perod. For a revew of the theory of ndex numbers, see Dewert (1987). 6 For a revew of some of the problems wth the producer prce ndex, see Wynne and Sgalla (1993). Economc Revew Second Quarter

4 We now llustrate how these varous bases can arse n the CPI and revew ther quanttatve mportance. Substtuton bas The CPI s estmated from a seres of samples because of the mpossblty of trackng the prces pad by every urban consumer for every purchase he or she makes. The frst part of the samplng process s to fgure out what t s that people buy and how ther expendtures are dstrbuted over the dfferent goods and servces that make up consumer spendng. At present, the weghts used to aggregate the prces of the dfferent goods and servces are based on expendture patterns durng the perod The CPI s a fxed-weght ndex, meanng that the weghts used to aggregate the prces of the dfferent goods and servces are held constant for relatvely long perods. (For an alternatve approach to evaluatng the bas due to the use of fxed weghts, see the box enttled Statstcal Approaches to Index Number Constructon. ) However, because the prces of all goods and servces do not change at the same rate, and because consumers can substtute less expensve for more expensve goods, over tme the weghts used to combne the prces become ncreasngly unrepresentatve of consumers actual expendture patterns. For example, f the prce of beef rses more rapdly than the prce of chcken, consumers wll typcally buy relatvely more chcken and relatvely less beef. Spendng on beef becomes less mportant n consumers budgets, whle spendng on chcken becomes more mportant. Because the CPI does not allow for these changng expendture patterns, t tends to overstate the ncrease n the cost of lvng over tme. The bas n the CPI due to ths phenomenon s known as substtuton bas. Substtuton bas s probably the best known and most frequently studed problem n the CPI. The most authortatve revew to date of measurement problems n prce ndexes concluded that estmates of substtuton bas that have so far been made ndcate that t s extremely small, so small that substtuton bas cannot be vewed as an mportant emprcal defect of fxed-weght consumpton prce ndexes (Trplett 1975, 66). The sze of the substtuton bas n a fxed-weght 4 cost-of-lvng ndex depends on two thngs: the extent to whch households substtute between goods n response to relatve prce changes and the extent to whch relatve prces change over tme. Absent ether of these factors, a fxed-weght Laspeyres ndex wll gve an unbased estmate of the true cost-of-lvng ndex. Thus, f household preferences are of the fxed-coeffcent or Leontef type, no substtuton occurs n response to relatve prce changes and the fxed-weght Laspeyres ndex s equal to the true cost-of-lvng ndex. Lkewse, f all prces ncrease or decrease together, relatve prces never change and agan the fxedweght Laspeyres ndex concdes wth the true cost-of-lvng ndex. It s unlkely, however, that ether of these condtons holds n practce. At the tme of Trplett s 1975 survey, the prncpal studes of substtuton bas n the CPI were Noe and von Furstenburg (1972), Chrstensen and Manser (1976), and Brathwat (1980) (whch crculated as a BLS workng paper n 1975). The major conclusons of these studes, whch are summarzed n Table 1, were that 1. the sze of the substtuton bas was small, probably no more than 0.1 percent a year, 2. the estmated magntude of the bas was relatvely nsenstve to the choce of functonal form for household preferences, 3. the estmated magntude of the bas ncreases wth the level of commodty dsaggregaton, and 4. the sze of the bas was greater durng perods of hgh nflaton when relatve prce fluctuatons were greater. Snce Trplett s survey, Manser and McDonald (1988) have revsted the problem of substtuton bas n fxed-weght Laspeyres-type ndexes. Manser and McDonald used consumpton data from the Natonal Income and Product Accounts (NIPA) for 101 commodtes over the perod to obtan two sets of estmates of the substtuton bas. Frst, usng nonparametrc methods and mantanng the assumpton of homothetc preferences (whch they test and are unable to reject) they calculate bounds on the sze of the substtuton bas n the Laspeyres ndex for the perod They calculate a maxmum possble bas of 0.22 percent per year and a mnmum possble bas of 0.14 percent per year.

5 Table 1 Studes of Substtuton Bas n the CPI Study Sample perod Categores covered Sze of bas Noe and von Furstenberg (1972) All.03 to.11 Chrstensen and Manser (1976) Meat and produce.1 to.2 (four categores of each) Brathwat (1980) All.1 Manser and McDonald (1988) All.14 to.22 Rensdorf (1993) Food and gasolne.25 to 2 Azcorbe and Jackman (1993) All.2 to.27 NOTE: Bas s expressed n percentage ponts. Second, usng superlatve ndex numbers to calculate changes n the cost of lvng, they estmate a substtuton bas of about 0.18 percent per year over the same perod. 7 More recently, Azcorbe and Jackman (1993) examned the ssue of substtuton bas usng even more dsaggregated data, specfcally, the consumer expendture data used to construct the CPI. They compare measures of prce change over the perod and arrve at an estmate of the substtuton bas over ths perod of 2.6 ndex ponts (an average of 0.2 percent a year) when a fxed-weght Laspeyres ndex s compared wth a fxed-weght Tornqvst ndex. The estmated substtuton bas s somewhat hgher (0.27 percentage ponts a year) when chan-lnked ndex numbers are compared. Azcorbe and Jackman argue that these estmates are small and conclude by notng the desrablty of havng some measure of whether the estmated bas s sgnfcant n a statstcal sense. The fndngs of these studes of substtuton bas n the CPI are summarzed n Table 1. 8 The bottom lne on substtuton bas s that ths partcular form of bas n the CPI s probably relatvely unmportant quanttatvely, amountng to at most 0.2 percentage ponts a year. Ths concluson s shared by Trplett (1975, 1988) and Gordon (1992), among others. However, recent work by Moulton (1993) shows that the ssue s not yet settled. Moulton examned substtuton effects wthn CPI product categores (or strata, as they are called by the BLS) and showed that substtuton effects wthn product categores are n some cases larger than those between categores. Ths s hardly surprsng: t s plausble that consumers should be more wllng to substtute between dfferent types of frut than between, say, frut and meat. Moulton looks only at data for the perod from June 1992 to June 1993, and t remans to be seen how hs fndngs generalze to other sample perods. Insofar as substtuton bas s consdered a problem n the CPI, t could be handled n one of two ways. One s to update the expendture weghts more frequently: currently the expendture weghts are updated about once a decade, the most recent revson occurrng n 1987, when expendture patterns from the Consumer Expendture Survey replaced those from the survey. Updatng the weghts every year (or every quarter) would consttute a shft from a fxed-weght to a chan-lnked or multweghted ndex. 9 The Unted Kngdom uses ths approach n 7 A superlatve ndex number s one that provdes a secondorder approxmaton to the true cost-of-lvng ndex for a large class of preference specfcatons. See Dewert (1976). 8 We do not revew the results of two recent studes by Kokosk (1987) and Blsard and Blaylock (1991) that examne the relatonshp between demographc factors and substtuton bas. 9 For a dscusson of the merts of chan-lnked prce ndexes, see Forsyth and Fowler (1981) and Szulc (1983). Economc Revew Second Quarter

6 Statstcal Approaches to Index Number Constructon Bryan and Cecchett (1993) adopt a novel approach to estmatng the bas that arses from the use of fxed weghts n the CPI. The essence of ther approach s to estmate the common (nflaton) factor n a number of the subcomponents of the CPI and nterpret the dfference between the estmated common factor and the CPI as an estmate of what they term the weghtng bas n the CPI. Estmaton of a common nflaton factor s essentally the same as constructng a prce ndex where the ndvdual prces are weghted on the bass of the strength of ther common nflaton sgnal. The estmates of weghtng bas they obtan average 0.60 percentage ponts a year over ther full sample, whch ranges from 1967:1 to 1992:12, wth a standard error of 0.17 percentage ponts. They also estmate the bas for two subsamples, fndng that the CPI overstated nflaton by about 0.88 percentage ponts annually durng , whereas the bas was essentally zero ( 0.07 percentage ponts wth a standard error of 0.13 percentage ponts) durng the perod. 1 Insofar as substtuton bas s a specal form of weghtng bas, ther fndngs confrm the earler results that substtuton bas tends to be hgher durng perods of hgh nflaton, whch typcally are also perods of substantal relatve prce varablty. The Bryan and Cecchett study s not really comparable to the other studes of substtuton bas dscussed n our artcle. As we have already noted, substtuton bas s defned as the dfference between the CPI as constructed and a true cost-of-lvng ndex. Bryan and Cecchett are nterested n the CPI as a measure of nflaton rather than as a measure of the rate of ncrease n the cost of lvng. In many ways, ther paper could be consdered to be a contrbuton to the statstcal approach to ndex number constructon that had ts orgns n work by Jevons and Edgeworth but has snce been largely abandoned n favor of the behavoral approach. For further detals on the dstncton between the statstcal and behavoral approaches, see Dewert (1987). Other recent contrbutons to the statstcal approach are Clements and Izan (1987) and Dow (1993). 1 Bryan and Cecchett ratonalze the possblty of a negatve, or downward, weghtng bas n the CPI by pontng out that for some tme perods and some goods, expendture shares and prce changes mght be postvely correlated f there s a taste shock that rases demand for the good. constructng ts measure of retal prces. Schmdt (1993) examnes the consequences of recalculatng the CPI usng more recent expendture patterns and fnds that the dfferences for estmates of annual nflaton rates are no more than 0.2 percent. The second alternatve s to construct an ndex usng a superlatve ndex number formula, such as the Tornqvst or Fsher ndex number 10 For further detals on Fsher and Tornqvst ndex numbers, see Dewert (1987). formulas, nstead of the Laspeyres formula currently used. Superlatve ndex numbers have the desrable property of beng exact for a class of utlty functons that are second-order approxmatons for any utlty functon and are thus less susceptble to substtuton bas. 10 Both of these possbltes are now feasble snce the Consumer Expendture Survey has been conducted on an ongong bass snce Kokosk (1989) descrbes ongong BLS research nto usng superlatve and chan ndexes to track prce movements. However, use of chan ndexes entals some sacrfce n terms of the tmelness wth whch the nflaton estmates can be obtaned, as t takes 6

7 more tme to collect and process nformaton on consumer expendture patterns than t does to collect and process nformaton on prces. Furthermore, dependng on the behavor of relatve prces, chan ndexes may be just as prone to substtuton bas as fxed-weght ndexes and n some cases, more so. 11 Note that the Bureau of Economc Analyss (BEA) recently ntroduced chanlnked superlatve prce ndexes for gross domestc product (GDP) and ts major components. 12 Outlet substtuton bas Once the BLS has determned how consumers allocate ther expendtures across dfferent goods and servces, t then has to determne whch varetes of the goods wll be prced for the CPI. For example, suppose the BLS determnes that urban consumers allocate some fracton of ther expendtures to buyng apples. The BLS then has to decde whch varetes of apples t wll prce for calculatng the CPI (n other words, Granny Smth, Golden Delcous, or whatever) and also where t wll obtan these prces. The choce of outlet where prces are obtaned s potentally very mportant. In an early study of the postwar growth performance of the U.S. economy, Denson (1962) argued that the prce statstcs used to deflate consumer spendng were based upward because the BLS typcally reled on hgher prced stores to obtan prce quotes for varous tems n the CPI, neglectng the postwar shft n consumer spendng patterns toward lower cost retalers and away from more tradtonal hgher prced outlets. Persstent prce dsperson n the retal market s essental for consumer gans from swtchng outlets not to be reflected n the CPI. Such persstence may arse due to market dsequlbra or nformaton costs. An ndex that tracks prces at ncumbents s based f qualty-adjusted prces at ncumbent retalers fal to declne to match those of the new retaler. The BLS looked nto ths potental source of bas n the CPI nearly thrty years ago and concluded at that tme that t was not a problem, clamng that the sample of outlets used for obtanng prce quotes was qute representatve of how consumers actually shopped. 13 The concern that there mght be an outlet substtuton bas n the CPI has recently come to the fore once more because of the rapd growth n low-cost, hghvolume dscount stores such as Wal-Mart, Sam s Club, Prce Club, and so on durng the 1980s. Further examples of ths trend are the growth n home shoppng and the ncreasng market share of factory outlet stores. 14 Table 1 reports the estmates of the outlet substtuton bas obtaned by Rensdorf (1993), snce bas n the CPI as a result of consumer substtuton toward lower prce retal outlets s n some sense analogous to the standard substtuton bas n a fxed-weght ndex as a result of commodty substtuton. Rensdorf offers two types of evdence on the sze of the outlet substtuton bas n the CPI. Frst, he compares the prces at ncomng and outgong CPI retaler outlet samples, and second, he compares the evoluton over tme of unlnked sample average prces and ther (lnked) CPI component counterparts. 15 Comparng prces at new and old outlets, Rensdorf obtans an estmate of upward bas n the food-at-home component of the CPI of 0.25 percent a year and a comparable fgure for the motor fuel component. Rensdorf notes that ths fgure may overstate the true sze of the bas f average qualty declnes along wth average prces. Rensdorf s second test compares the growth of the Average Prce seres publshed by 11 For detals, see Forsyth and Fowler (1981) and Szulc (1983). 12 For detals, see Young (1992) and Trplett (1992a). 13 The ssue of outlet substtuton was also dscussed by the Stgler Commttee (NBER 1961, 58) and, n more detal, by Backman and Gansbrugh (1966, 29 31). Backman and Gansbrugh cte studes by the BLS and Wllard Arant that put the magntude of ths bas at no more than a couple of tenths of a percentage pont a year. 14 See, for example, Hellker (1991). 15 When new tem outlet combnatons are rotated nto the CPI, all the dfference n prce between the old tem outlet combnaton and the new tem outlet combnaton s assumed to be due to a dfference n qualty. Ths s the way n whch the prce quotes that go nto the CPI are lnked together. By contrast, for the Average Prce program, all of the dfference n prce between old tem outlet combnatons and new tem outlet combnatons s assumed to be due to dfferences n prce. Thus, the Average Prce seres are sad to be unlnked. Economc Revew Second Quarter

8 the BLS wth that of the correspondng components of the CPI. 16 For food durng the 1980s, varous components of the CPI rose more rapdly than the correspondng Average Prce seres, yeldng an mplct estmate of outlet substtuton bas of almost 2 percent a year. Whle qualtyadjustng the Average Prce food ndexes mght reduce some of the dfference wth the CPI, t would not elmnate t completely snce the wllngness of consumers to shft to low-cost retalers presumably ndcates that the qualty dfference must be more than compensated for by the better prces. For gasolne the estmated bas s 0.3 percent per year. Rensdorf notes that the estmates obtaned from a comparson of Average Prces wth the CPI should be taken as upper bounds on the amount of substtuton bas, snce no attempt s made to control for the possblty that the average qualty of outlets may have declned. In vew of the mportance that some analysts have attached to Rensdorf s fndngs (see, for example, Gordon 1992 and The Economst 1993), t s mportant to be explct about the caveats that accompany hs results. 17 One s that outlet substtuton and varety substtuton typcally occur at the same tme. To the extent that ths allows the substtuton n the CPI sample of, say, a (low-cost) store-brand tem for a name brand tem, some of the dfference found by Rensdorf may be smply due to swtchng brands. Also, t s mportant to try to quantfy the qualty dfference between dfferent retal outlets to get a proper handle on the sze of the bas. Popkn suggests 8 16 Average Prces are estmated from CPI data for a lmted number of goods and are calculated as weghted averages of prce quotes obtaned for a representatve varety of the good n queston. For further detals, see U.S. Department of Labor (1992, 199). 17 See, for example, Popkn (1993). 18 On the latter, see, for example, Hrsch (1993), who notes, Seekng to stanch ther fnancal hemorrhagng, most arlnes are puttng fewer attendants on board ther arcraft. The result: Passengers wat longer for meals and beverages; meal carts clog the asles longer; drty trays stack up; and obtanng the lttle extras of lfe aloft a pllow, a magazne, a drnk of water s often a do-t-yourself experence. the use of hedonc type regressons of the sort used to make adjustments n the apparel ndexes to determne the approprate qualty adjustments for outlets. Fxler (1993) notes that comparson of Average Prce seres wth correspondng CPI seres does not provde drect evdence of outlet substtuton bas because outlet swtchng s not the only source of dfference between the two seres. Qualty bas If a poll were taken of professonal economsts and statstcans, n all probablty they would desgnate (and by a wde majorty) the falure of the prce ndexes to take full account of qualty changes as the most mportant defect n these ndexes. And by almost as large a majorty, they would beleve that ths falure ntroduces a systematc upward bas n the prce ndexes that qualty changes have on average been qualty mprovements (NBER 1961, 35) [emphass added]. There s a general percepton among economsts that qualty bas s probably the most serous shortcomng of the CPI, causng t to overstate the true rate of ncrease n the cost of lvng. Ths percepton probably reflects two other belefs. Frst, that the average qualty of all goods s ncreasng over tme and, second, that the BLS does lttle or nothng to take qualty mprovement nto account when calculatng ts prce ndexes. As we wll see, nether of these statements s completely true. Whle t s the case that the qualty of most products does seem to mprove over tme, we should not overlook the obvous examples where qualty seems to deterorate for example, the ncreased use of graduate students for undergraduate nstructon at major unverstes, the dsappearance of full-servce gas statons, and the declne n the qualty of n-flght servce on some arlnes. 18 Second, the BLS has a number of methods for dealng wth qualty change. The queston then becomes how adequately do these methods capture changes n the qualty of the products sampled for the prce ndexes. We wll see that n some cases the BLS may n fact overadjust for qualty change n calculatng the prce ndexes, causng them to understate the true rate of nflaton.

9 How the BLS deals wth qualty change The qualty adjustment problem n constructng a prce ndex may be stated as follows. 19 Suppose some partcular varety of a good s selected for ncluson n the CPI. Suppose further that at some later date, the chosen varety dsappears and s replaced by a newer model. How do we compare the prce of the old varety of the good n the earler perod wth the prce of the new varety n the later perod? As a concrete example of ths problem, consder how we would compare the prce of an older model VCR wthout remote control capablty wth the prce of a newer model VCR that has remote control capablty. Snce hgher qualty goods are typcally more expensve than lower qualty goods, a drect comparson of the prces of the two varetes would result n an overestmate of how much prces have ncreased. 20 The approprate comparson of prces requres that we compare prces for goods of the same qualty. In the VCR example, we need to somehow adjust the prce of the model wth remote control capablty for the mprovement n qualty that remote control represents. In practce, the BLS has a number of methods for dealng wth qualty change. The BLS categorzes the methods t uses to deal wth new product varetes or qualty change as follows: (1) drect comparson, (2) drect qualty adjustment, and (3) mputaton. In drect comparson, f the two varetes are judged to be suffcently smlar n terms of qualty n some well-defned sense, all the observed dfference n prce between the new and old varetes of the product s counted as a prce change, and nothng more s done. The rsk here, of course, s that some unnotced qualty change s nadvertently beng treated as a prce change, mpartng an upward bas to the CPI. If, however, the varetes are judged to be dfferent n some meanngful sense, the BLS makes some form of drect qualty adjustment usng one of a number of dfferent methods. 21 The smplest case s when the two varetes are observed n some common perod, n whch case t s possble to obtan overlappng prce quotes for the two varetes. In ths stuaton, the rato of the two prces n the perod of overlap s taken as the qualty adjustment. For example, f a VCR wthout remote control costs $200 whle one wth remote control costs $220, the $20 prce dfference between the two varetes can be consdered an estmate of the value of remote control capablty to consumers. The problem wth ths adjustment procedure s that we rarely observe overlappng prces for new and old varetes. An alternatve s to make an adjustment based on the manufacturer s producton cost dfferences for the two varetes. In ths case, the manufacturer s asked to estmate the cost dfference for the two varetes, whch s then scaled up to the retal level and added to the prce of the old varety n the ntal perod to obtan an estmated prce for the new varety n the prevous perod. Ths form of qualty adjustment, n use snce around 1960, s used most frequently n valung qualty changes n automobles. 22 Another form of qualty adjustment, and the one that serves as the bass of most studes of 19 Ths dscusson follows Trplett (1988). See also Armknecht and Weyback (1989), Armknecht and Gnsburg (1992), U.S. Department of Labor (1992), Gordon (1992), and Kokosk (1993). 20 Computers seem to be an excepton to ths rule, and as a result, the problem of qualty-adjustng computer prces has attracted a lot of attenton. Some of ths research s revewed n Wynne and Sgalla (1993). For more detaled revews, see Trplett (1989) and also the chapter on computer prces n Gordon (1990). 21 Trplett and McDonald (1977) use a hedonc prce functon to evaluate the judgment of the BLS commodty specalsts as to whether specfcaton changes for refrgerators are major or mnor. Durng ther sample perod ( ), there were seventy-sx changes n the specfcatons of refrgerator-freezers prced for the Wholesale Prce Index (WPI). In forty-sx of these cases the BLS judged that the changes were mnor, and no qualty adjustments were made. Trplett and McDonald apply a qualty adjustment to twenty of these forty-sx cases. Of the remanng thrty cases that were judged by the BLS to be major, Trplett and McDonald apply a qualty adjustment to twenty-fve. 22 Gordon (1981) notes that a problem wth ths procedure s that a manufacturer may overstate the cost of a qualty mprovement to dsguse some part of an actual prce ncrease, especally when prce controls or gudelnes are n force. Economc Revew Second Quarter

10 qualty bas n the CPI, entals estmatng a hedonc regresson that relates the prces of dfferent varetes of a good to the characterstcs of the dfferent varetes. 23 The estmated parameters from such a regresson provde mplct prces for each of the prce-determnng characterstcs of the good. Thus, when a new varety of a product that dffers from the exstng varety n terms of some or all of the relevant characterstcs becomes avalable, t s straghtforward to make a qualty adjustment on the bass of the hedonc regresson. Despte the ntal promse of hedonc technques, however, these technques have not proven to be a panacea n dealng wth the problem of qualty change. 24 Specfcally, hedonc technques are not able to deal wth qualty changes that are not easly quantfed (such as the handlng characterstcs of a car, the multtaskng ablty or portablty of a personal computer, the qualty of care durng a hosptal stay, or whether an tem of clothng s n or out of fashon). In some stuatons, the BLS has not yet determned how best to make qualty adjustments. New product varetes that can be nether drectly compared nor qualty adjusted are called noncomparable, and n these stuatons, the BLS estmates the constant-qualty prce change by mputaton. The most common type of mputaton for noncomparable substtutons n the food and servces categores conssts of settng the rate of prce change for the new and old varetes equal to the average prce change for smlar goods. The mplct assumpton that treatng noncomparable substtutons n ths manner s bengn s questonable. For example, t s qute lkely that the new product s n the early stage of ts product cycle and experencng substantal prce declnes, whle the products used to mpute the prce change are Hedonc methods are revewed n Trplett (1987, 1986) and Grlches (1971). Grlches (1961) s the semnal applcaton of hedonc methods to evaluatng the qualty bas n the CPI. 24 See, for example, Trplett (1988) and Gordon (1990). 25 See Armknecht (1984, 58). probably mature products that are experencng prce ncreases. The nherent dffculty of decdng whether new products, or new varetes of exstng products, are comparable to old s the essental source of qualty error n the CPI. When a new (hgher prced) product s deemed comparable wth an old product, some qualty change may be ncorrectly treated as prce change, leadng to an upward bas n the CPI. When the new product s deemed noncomparable, some prce change may be ncorrectly treated as qualty change, leadng to a downward bas n the CPI. 25 How bg s the qualty bas n the CPI? Snce the Stgler Commttee Report n 1961, numerous studes have attempted to estmate the extent of qualty bas n the CPI. It s not a smple matter to use the results of these studes to nfer the extent of qualty bas n the CPI as t s currently constructed because the methods used by the BLS have evolved over tme, partly n response to these studes. Trplett (1975) concluded hs survey of qualty bas n the CPI by notng that...the research results mply that no smple estmate of the overall qualty error can be made, and, moreover, even the sgn of the error s n doubt (Trplett 1975, 48). In concludng a more recent revew of research on prce ndexes, Trplett was even more emphatc about the uncertanty surroundng the sgn and magntude of the qualty bas n the CPI, notng that...because a number of large CPI components appear qute clearly downward based, I suspect that the CPI has, f anythng, understated nflaton n the last several years (Trplett 1988, 67). What components of the CPI are downward based, and how large are the bases? The frst component of the CPI that Trplett suggests contaned a downward bas was housng. Before 1988, when estmatng the shelter cost component of the CPI, the BLS dd not take nto account the deteroraton n housng stock qualty as a result of agng and deprecaton. Randolph (1988) shows that falure to allow for deprecaton n the housng components of the CPI cause the shelter cost ndexes to be downward based by as much as 0.3 to 0.4 percent annually. However, snce 1988

11 the BLS has made adjustments to the shelter components of the CPI to allow for agng. 26 Another source of downward bas n the CPI s n the ndexes for apparel and clothng. Here Trplett ctes the almost mpossble task of separatng taste or fashon changes from qualty changes and the strong seasonal pattern n clothng styles as sources of error n the CPI treatment of clothng. One pece of evdence of downward bas n the apparel ndexes comes from a comparson of the rates of nflaton for nfants and toddlers apparel, whch presumably s less subject to fashon cycles, wth those for men s and boys apparel and women s and grls apparel. In the perod, the ndex for nfants and toddlers apparel grew at a 6-percent average annual rate, whle those for men s and boys apparel and women s and grls apparel grew at 3.4 percent and 2.9 percent, respectvely, suggestng that the BLS may have overadjusted for qualty change n these categores. Armknecht and Weyback (1989) and Legey (1993) provde further evdence of the lkely downward bas n the apparel components of the CPI. Trplett also argues that auto prces are downward based because of the manner n whch the BLS treats mandatory safety and polluton devces. Specfcally, the BLS treats these changes as qualty mprovements rather than prce ncreases, as the theory of the cost-of-lvng ndex ndcates they should be treated. 27 Trplett (1992b) presents evdence to suggest that frequently these mandatory changes account for a sgnfcant proporton of the estmated qualty change n autos. 28 Further nsght on the quanttatve sgnfcance of these mandatory changes can be obtaned from Gordon (1990), who dsentangles the varous components of the qualty adjustments appled to the auto component of the CPI (see Gordon 1990, Table 8.10). Gordon shows that over the perod , qualty adjustments reduced the average annual rate of ncrease n the auto component of the CPI from 7 percent to 4.3 percent. Furthermore, safety and envronment related qualty adjustments account for 2 percentage ponts of the 2.7 percent dfference between the unadjusted and adjusted CPIs for autos. The canddates for upward bas Trplett dentfes are servces, used cars, and mscellaneous other. The problems wth measurng the prces of servces accurately, and especally the prce of medcal care, are well known. We wll return to the measurement of servce prces n more detal below. For used cars, the problems stem from the nadequate qualty adjustments made to prce observatons for used cars, although snce 1987 the BLS has been makng adjustments based on the qualty adjustments for new cars. As for the mscellaneous other category, Trplett ctes the dffculty of dealng wth the subtle substtutons between restrcted and unrestrcted arlne fares as a source of possble upward bas n the CPI. Untl recently, the BLS prced unrestrcted full-fare arlne tckets n calculatng the CPI, although relatvely few people purchased such tckets. Table 2 summarzes the prncpal studes of qualty bas n the CPI that have appeared n the past fve years. Probably the sngle most mportant recent pece of research on the problem of qualty change and prce measurement s Gordon s (1990) study of durable goods prces. Whle Gordon s prmary objectve s to obtan mproved estmates of the prces of producer durables for better deflaton of the producers durable equpment (PDE) component of nvestment n the natonal accounts, he also looks at selected categores of consumer 26 These adjustments are descrbed n more detal n Lane, Randolph, and Berenson (1988). 27 Ths s probably too extreme. Presumably some consumers would be wllng to pay for extra safety features even f they were not mandated by the government, and for these consumers the safety mprovements do consttute qualty mprovements. We thank Evan Koeng for ths pont. 28 See Trplett (1992b) Table 7.1. Most recently (November 1993), the BLS estmated that the retal equvalent value of qualty changes for 1994 model passenger cars averaged $363.63, just under two-thrds the average ncrease n manufacturers suggested lst prces of $ The $ estmated retal value of qualty changes could be further broken down nto $ assocated wth changes n accordance wth mandated polluton and safety features and $ for other qualty mprovements, such as powertran mprovements, corroson protecton upgrades, and changes n levels of standard or optonal equpment. Economc Revew Second Quarter

12 Table 2 Recent Studes of Qualty Bas n the CPI Study Categores studed Sample perod Estmated bas Noe and von Furstenberg (1972) All.03 to.11 Armknecht and Weyback (1989) Women s coats and jackets, to 3.5 women s suts Randolph (1988) Housng to.4 Gordon (1990) Durables Legey (1993) Women s coats and jackets, to 6 women s suts NOTE: A negatve bas means that the CPI understates the rate of nflaton of the tem. durables. 29 Gordon concludes that the CPI overstated the rate of ncrease n durables prces by an average of 1.54 percentage ponts a year over the full sample, wth the largest errors occurrng before Table 3 summarzes the detals of Gordon s fndngs on the bases n the offcal estmates of consumer durables prces. The fgures n Table 3 are the average annual rate of drft of the rato of Gordon s alternatve prce ndexes for the ndcated categores to the offcal prce ndex, where both the alternatve and offcal ndexes are constructed usng the Tornqvst ndex number formula. (For a descrpton, see the box enttled Tornqvst Index Numbers. ) The negatve drft n all the prce ratos over all the sample perods Gordon examnes suggests that the CPI sgnfcantly overstated the rate of prce ncrease for these categores of goods for the ndcated perods. Gordon notes that whle the rate of drft, or error, for the applance and rado TV categores of durables may appear surprsngly hgh, the data used to construct these ndexes are among the most accurate and comprehensve parts of hs study. The dfference between Gordon s prce Indeed, t s arguable that, gven the data sources Gordon reled upon (the Sears catalog, Consumer Reports), hs results are more relevant for assessng potental problems n the CPI than the PPI. seres and the offcal prce seres s attrbutable to Gordon s use of alternatve sources for hs prce data n conjuncton wth a more rgorous applcaton of qualty adjustments when such adjustments are called for. Gordon uses hedonc methods to qualty-adjust prces when data allow ther use, but for most of the data, qualty adjustment s carred out usng exstng BLS technques. Agan, we need to nterpret these results wth cauton. Trplett (1993) argues that by followng the BLS conventon on the treatment of government-mandated polluton and safety features on durable goods, Gordon omts a sgnfcant source of downward bas n automoble prces. Thus, Gordon overestmates the sze of the overall qualty bas n durable goods prces, possbly by as much as one-thrd to one-half. New goods bas In some respects, the new goods problem s smply another verson of the qualty adjustment problem: the dstncton between a new varety of an exstng product and an entrely new product s not always obvous. For example, a personal computer can be consdered a new product, or t can be vewed as an extraordnarly effcent combnaton calculator and typewrter. Fxler (1993) suggests that a qualty change be defned as a change n a product s characterstcs and a new good be defned as a rebundlng of a product s characterstcs or the addton of new characterstcs.

13 Table 3 Drft of Rato of Tornqvst Indexes Gordon s study and Correspondng NIPA Implct Deflators for Selected Consumer Durables, 1982 base Annual growth rates Full sample Motor vehcles and parts Furnture and household equpment Ktchen and other household applances Rados and TV s Total consumer durables SOURCE: Gordon (1990). Table 1.2. NOTE: The table shows the drft n the rato of Gordon s alternatve prce ndexes to the offcal prce ndexes for dfferent perods. Thus, negatve numbers are nterpreted as showng that the offcal seres are upward based; that s, they overstate nflaton. The essence of the problem posed by the arrval of new goods s as follows. 30 Suppose we are tryng to track a measure of the prce level over tme, and we have prce and quantty data for N 1 commodtes n perods 1 and 2, p n t and x n t for t = 1,2 and n = 1,...,N 1. Suppose, n addton, that x N 2 unts of a new good are sold at prce p N 2 n perod 2. How are we to calculate the blateral prce ndex P (p 1,p 2,x 1,x 2 ) when we do not know p N1, the prce of the new good n perod 1? Stated ths way, the smlarty between the problem posed by new goods and qualty change n exstng goods becomes clear. 31 Whle there do not appear to be emprcal studes of the new goods problem as such, an example from Dewert (1987) s llumnatng and gves us some sense of the potental magntude of the problem. Dewert estmates that, dependng on the fracton of expendtures allocated to new products not covered by the prce ndex and the prce profle of new products (typcally, new products experence rapd prce declnes followng ther ntroducton), the prce level would be overstated by between 1 and 5 percent annually when calculated usng the Laspeyres formula. Lebow, Roberts, and Stockton (1992) attempt to put more concrete numbers on the sze of the new goods bas by makng some smple assumptons. They solate the CPI categores n whch they thnk rapd product nnovaton s most lkely to be mportant and fnd that the relevant categores account for about 2.4 percent of the CPI. Assumng that new products experence prce declnes at a rate comparable to that of computers that s, about 20 percent a year on average they arrve at an estmate of new goods bas n the overall CPI of 0.5 percent a year. Insofar as new goods are mportant n categores other than applances, lawn equpment and power tools, and medcal care commodtes, the 0.5 percent fgure s an underestmate of the sze of the new goods bas. 30 Ths dscusson follows Dewert (1987). 31 A formal soluton to ths problem was proposed by Hcks (1940). Smply calculate the shadow prce that would just make the consumer s demand for the good n perod 1 equal zero. The calculaton of ths shadow prce requres knowledge of the consumer s preferences, whch mght be obtaned by econometrc technques. In practce, however, t s too costly to resort to such technques, and offcal ndexes frequently gnore new goods. Cars were not ntroduced nto the CPI untl 1940, whle the PPI dd not nclude computer prces untl Economc Revew Second Quarter

14 Tornqvst Index Numbers A Tornqvst prce ndex s defned as where s 0.5 P T = s 2 p, 1 p p 1 1 x p 1 x + p 2 2 x 1 2. p 2 x The nterpretaton of an ndex number of ths type s a lttle clearer f we rewrte t n logarthmc form: log(p T ) = s(log(p 2 ) log(p 1 )). That s, the (log of the) Tornqvst ndex s a weghted average of the growth rates of the ndvdual prces, wth weghts equal to the average of the expendture shares n the two perods used to compute the growth rates. The choce of the Tornqvst ndex number formula s motvated by the fact that t belongs to the class of superlatve ndex numbers dentfed by Dewert (1976). Superlatve ndex numbers have the property that they are exact for utlty functons that are secondorder approxmatons for any utlty functon and are thus less susceptble to substtuton bas. If most new goods do not experence prce declnes comparable to those experenced by computers, the 0.5 percent fgure s an overestmate of the sze of the new goods bas. The man reason computer prces seem to have been examned so frequently s because they have declned at such extraordnarly rapd rates. New goods bas could well be a lot hgher or a lot lower than ther calculaton suggests; we smply do not know. Lst versus transactons prces As we have already noted, the prce nformaton that goes nto the CPI s collected by BLS feld representatves through vsts or telephone calls. The BLS puts great emphass on obtanng prce quotes that reflect the actual prces pad by consumers, and to ths end, t makes a number of adjustments to some of the raw prce data to U.S. Department of Labor (1992, ). 33 In contrast, a number of studes address the lst transacton prce problem for the PPI. obtan better estmates of transactons prces. For example, n prcng new cars, the BLS agents obtan estmates of the base prce for the vehcle, along wth estmates of the prces of varous optons, dealer preparaton, and delvery. The BLS agents also obtan estmates of the average concesson or markup durng the prevous thrty days to arrve at an estmate of the transacton prce of the vehcle. The BLS also tres to take account of manufacturers rebates, bonus merchandse, quantty dscounts, and utlty refunds when prcng many other goods and servces. 32 However, no adjustment s made for the use of cents-off coupons by consumers, except when the coupons are attached to the product for mmedate redempton at the tme of purchase. There seems to be no research on how accurately the prces that are used to construct the CPI reflect the actual prces pad by consumers. 33 It would appear that the BLS does make a reasonable attempt to ensure that the prces are accurate, but the falure to account for the use of cents-off coupons does rase some questons. Data on coupon use s dffcult to come by, although we can get some sense of ther potental mportance from Nelsen Clearng House (1993). Accordng to the Nelsen Report, n 1992 consumers redeemed about

15 7.7 bllon manufacturer-ssued coupons, whose face value averaged 58 cents, for total savngs of $4.5 bllon, whch s slghtly less that 1 percent of consumer spendng n the relevant categores. Somewhat more than 14 percent of total grocery volume was purchased wth a coupon n Growth n the average face value of coupons redeemed has consstently exceeded growth n the CPI snce It s an open queston whether falure to allow for the use of cents-off coupons by consumers leads to an upward bas n the CPI and, f so, by how much. Treatment of durable goods The theoretcal bass of the cost-of-lvng ndex and the CPI s essentally a statc theory. The approprate treatment of durable goods n such an ndex requres the measurement and prcng of the flow of servces obtaned by the consumer from the good over tme. That s, snce a durable good yelds a flow of consumpton servces valued by the consumer over several tme perods, we do not want to prce the purchase of the good but rather, the flow of servces that t yelds each tme perod. In 1983, the BLS swtched to the rental equvalence concept to measure housng costs n the CPI (1985 for the CPI W). Part of the mpetus for ths change was the large dscrepancy that emerged n the late 1970s between the CPI and the deflator for personal consumpton expendtures (PCE) n the natonal accounts due to ther dfferent treatment of housng costs. It became generally recognzed that the rental equvalence approach employed n the constructon of the PCE deflator was superor on theoretcal grounds. 34 Before the change, the BLS was accused of mxng the consumpton and nvestment components of housng costs. The approprate concept for a cost-of-lvng-based ndex s the cost of the flow of housng servces consumed over the measurement nterval. However, the rental equvalence approach s not wthout ts problems. There are mportant dfferences between the markets for owner-occuped homes and the markets for rental unts, not least of whch s the qualty. Pror to the 1987 revson of the CPI, the BLS smply took fgures from the CPI s rental component to estmate the mplct rent of owner-occupers. Snce 1987 the BLS has used rents from houses n the same geographc area and wth smlar characterstcs to those of owneroccuped houses to calculate the owners equvalent rent ndex. Armknecht and Gnsburg (1992) descrbe research currently beng undertaken at the BLS to shft the treatment of autos n the CPI to the theoretcally more approprate flow-of-servces approach. Under deal crcumstances, all durable goods would be prced on a flow-of-servces bass. In realty, ths s not possble, prmarly because there are no rental markets for many types of durable goods. 35 For autos, however, two very actve and dstnct rental markets may facltate the adopton of a rental equvalence approach. Armknecht and Gnsburg pont out that car use n the tradtonal (short term) rental market s very dfferent from normal use, makng t unrepresentatve of the general populaton. However, the long-term rental market for auto leases may provde more approprate measures of the rental equvalence of auto servces. The BLS currently s examnng the feasblty of prcng auto transportaton servces on ths bass. Measurng the prces of servces Trplett s 1975 survey revews a small number of studes that attempt to assess the qualty of the CPI servce prce ndexes. Four of the sx studes he revews examne the medcal servces component of the CPI, and three of these four fnd upward bas n the CPI components. However, the man concluson that Trplett draws from these studes s that the approprate prcng concept n the medcal servces area s not very well defned. Should we be prcng treatments or cures? Prcng a cure may well be the approprate approach, but, as Trplett notes, cures have multple characterstcs that are dffcult to value. For example, how should we compare the cost of treatng appendcts by 34 See, for example, Blnder (1980), Gordon (1981), and Dougherty and Van Order (1982). 35 As Armknecht and Gnsburg note, there s no rental market for shoes. Economc Revew Second Quarter

16 surgery versus treatng t wth drugs when the latter treatment s accompaned by an ncreased rsk of a ruptured appendx? Trplett concludes hs 1988 revew by notng that...exstng research on the subject s nsuffcent to ndcate whether the medcal care components are upward based (Trplett 1988, 70). However, the BLS handbook qute explctly states that n many nstances qualty changes are treated as prce changes, ether because the BLS s unaware of the qualty change or has no method for dealng wth t. (U.S. Department of Labor 1992, 193). In nstances where qualty adjustment s feasble, t s carred out. 36 Kroch (1991) revews the problems of prce measurement n the servce sector and argues that the true rate of servce-sector nflaton s probably lower than the measured rate and closer to the rate n the goods sector. Kroch argues that the slower rate of nflaton for medcal equpment (whch s adjusted for qualty changes) than for medcal servces (for whch relatvely few qualty adjustments are made) s suggestve of an upward bas n the CPI medcal servces category. Kroch s Recently, Armknecht and Gnsburg (1992) have revewed the manner n whch the BLS has tred to deal wth the ncreasng mportance of servces n consumers budgets. They also have revewed research currently under way to mprove measurement and qualty adjustment of servces prces. They dscuss research that attempts to apply hedonc technques to the measurement of the prce of hosptal room stays and note the problem of properly accountng for and measurng dfferences n the level of nursng care among hosptals as a major obstacle to the mplementaton of hedonc methods n ths area. 37 Ths example was suggested by Jack Trplett. 38 However, the study by Rogers, Henderson, and Gnsburg (1993) suggests that the housng component of the CPI has performed qute well n recent years. 39 Kroch notes that nearly two-thrds of health care servces consumed n the Unted States are not part of the consumer budget because they are provded through employer-pad health plans rather than pad for drectly by consumers. Hence, medcal care prces are gven only a 4-percent weght n the CPI. Ths fgure ncludes household payments for health nsurance. By contrast, household consumpton of health servces accounts for more than 12 percent of personal consumpton n the Natonal Income and Product Accounts. See Kroch (1991, 32). comparson of the nflaton rates of the two seres suggests that medcal servces nflaton was overstated by as much as 1 percent a year durng the 1980s. However, t s not clear what one can nfer from a comparson of the rates of ncrease of nput and output prces. For example, the rate of nflaton for captal equpment used n the auto nsurance ndustry, whch s a heavy user of computers, s fallng rapdly, whch s not generally true of auto nsurance premums. 37 Kroch also argues that the educatonal prce category overstates nflaton when compared wth an ndex of tuton for hgher educaton. The last category of servces that Kroch consders s the rental equvalence measure of owner-occuped housng, and whle he suggests that the falure of the rental equvalence ndex to track house prces n recent years may mean that the CPI s overstatng nflaton n the housng servces category, he refrans from drawng a concluson. 38 It s, of course, mportant to remember that despte the dffcultes that may accompany prce measurement for many servces, the nfluence of these problems on the overall CPI s determned by the mportance of the problem categores n the consumers budget. Thus, even f t were true that nflaton n the medcal care component of the CPI s overstated, the fact the medcal care only accounts for 4 percent of consumers expendtures would greatly lmt the nfluence of msmeasurement n ths component on the overall CPI. 39 The categores of the CPI that Kroch argues may be overmeasurng nflaton together account for only 5.6 percent of budget outlays n the base perod. Conclusons about measurement bas n the CPI The pont of departure for ths revew of the CPI s the earler survey by Trplett (1975), wth ts concluson that, as of the md-1970s, not enough was known to determne whether there was a clear overall bas n the CPI or determne ts sgn. Trplett repeats ths opnon n hs unpublshed 1988 survey. Have we learned anythng n the ntervenng perod that would lead us to draw dfferent conclusons? In the almost twenty years snce Trplett s frst survey, there has been remarkably lttle new

17 research on the problems of prce measurement. Probably the most mportant sngle contrbuton to the feld of prce measurement n recent years s Gordon s (1990) study of producer durables prces, whch also ncludes some analyss of consumer durables prces. For the CPI, the most sgnfcant recent studes have been those of Manser and McDonald (1988) on substtuton bas and Rensdorf (1993) on outlet substtuton bas. There are no recent studes of qualty bas for the nondurables and servces components of the CPI. For example, we stll have no sense of how large the potental bas s n the measurement of health care costs. 40 It seems clear that the ssue of substtuton bas s the closest to beng settled. We probably can conclude wth some confdence that the substtuton bas arsng from the use of the fxedweght ndex s currently 0.2 percent a year at most. Recently, the ssue of outlet substtuton bas has receved a lot of attenton, prmarly as a result of the work of Rensdorf (1993). In vew of ths, we gve t more detaled coverage n our revew of the recent lterature and argue that t needs to be backed up by further work before the fgure of an upward bas of as much as 2 percent a year can be accepted as vald. 41 Note that the 2 percent fgure s for the categores studed by Rensdorf (food at home and gasolne) and does not apply to the CPI as a whole. We note that some categores of the CPI that Trplett ctes as havng potental downward bas, such as housng, are now treated dfferently, and agng bas s less lkely to cause nflaton of housng costs to be understated. Apparel remans a problem, although t s nterestng that the studes by Armknecht and Weyback (1989) and Legey (1993) fnd both upward and downward bas n ths category. Auto prces are stll based downward, for the reasons Trplett states, and wll reman so untl the BLS changes ts methodology. We have no frm evdence on the sze and nature of the bases n prcng medcal care and so cannot draw any frm conclusons about ths category. Lebow, Roberts, and Stockton (1992) conclude ther survey of measurement bas n the CPI by notng that under extreme assumptons, the upper bound on measurement bas s about 1.8 percent a year. They arrve at ths fgure by addng the varous bases that have been dentfed and quantfed by other authors. Whle calculatons of ths sort are suggestve, t s mportant to consder the lmtatons and caveats regardng them. Specfcally, we need to ask whether calculatons of ths sort may gve us fgures on the overall bas n the CPI that are too hgh because of double countng of some of the bases. Can we smply add together estmates of the qualty adjustment bas and the new goods bas, gven that the dstncton between the two s elusve? Is t possble that tradtonal substtuton bas and qualty adjustment bas are also aspects of the same phenomenon? The same queston can be rased for the outlet substtuton bas dscovered and quantfed by Rensdorf (1993): how do we dsentangle ths effect from other, more tradtonal forms of bas? How much of the dfference n prces between conventonal and low-cost retal outlets s due to a lst transactons prce problem that stems from the BLS s falure to account for the use of cents-off coupons at conventonal outlets? As Gordon (1990) notes n hs study of producer durable prces, and Trplett emphaszes n hs 1975 and 1988 surveys, the problem s that many potental ptfalls of the dfferent prce ndexes are consdered n solaton from one another, wthout any regard to the possble nteracton among them. Ths comment s not to crtcze the calculatons carred out by Lebow, Roberts, and Stockton. Such calculatons are essental f any sort of conclusons are to be drawn about the potental bases n the most closely watched prce ndex. However, t s mportant to be aware of, and at some pont do somethng about, the lmtatons that surround calculatons of ths type. In vew of the paucty of evdence on the varous potental bases n the CPI, we are nclned to thnk that t s better to err on the sde of con- 40 Thus, Tregarthen (1993) ponts out that recent concerns over the rsng cost of health care may be mstaken, n part because of the falure of the BLS to properly account for qualty change n health care and n part because of the relance of the BLS on lst rather than transacton prces n prcng the health components of the CPI. 41 It s mportant to note that Rensdorf hmself consders the 2 percent fgure to be at best a ballpark estmate rather than a pont estmate and that t may be capturng phenomena other than outlet substtuton. Economc Revew Second Quarter

18 servatsm n guesstmatng the sze of the overall bas. A fgure of less than 1 percent thus strkes us as a plausble estmate of the overall bas. The true fgure may be a lot larger or a lot smaller; at present we smply do not know. The more agnostc poston that Trplett has adopted n hs surveys s harder to defend, as the evdence seems to ndcate more nstances of upward than of downward bas n the CPI. However, Trplett s arguments are an mportant antdote to those who are nclned to accept uncrtcally the poston that the CPI consstently overstates nflaton. 18

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