If you haven’t read parts 1-4 of this series, you will probably want to do that before reading this installment on understanding inflation.
Hedonic Adjustments: Even though the price went up $2,000, the car still costs the same … what???
Since 1999, the CPI index has been adjusted using hedonics, which is a price adjustment for quality. Hedonics adjusts the price of goods, accounting for the increased pleasure that a consumer receives from the product. It works like this. Let’s say that a particular car prices out at $23,500. The model remains unchanged the following year except for a few minor adjustments by the manufacturer. They have made heated seats and navigation standard instead of options. Other than that, it’s basically the same car. The new price is $25,500. The price of the car appears to have increased by $2,000, but using hedonics, the government adjusts the price of the car, deeming the price to have remained unchanged. The government argues that you are getting more this year (heated seats and navigation) than the model offered last year; hence, they maintain that the price has NOT increased. You argue that the price has increased $2,000 and that you don’t need heated seats and navigation! You live in the South where heated seats aren’t necessary, and you do all your driving in your hometown with no need for a fancy navigation system. However, that line of reasoning does not matter to the government. Even though you paid more for your car than you would have paid last year, the government says that the price stayed the same, at least as far as the calculation of the Consumer Price Index is concerned. It’s easy to see how hedonic quality adjustments are subjective and open to manipulation.
Not all quality adjustments are subjective, though. Many are very objective and do a very good job at keeping CPI accurate. Many of you may have noticed that your groceries have been shrinking. Whether it’s your favorite chocolate bar, yogurt cup or bag of chips, you seem to be paying the same price but getting less. It’s not your imagination. As costs rise, manufacturers are bamboozling consumers by charging the same price and giving less. Rising dairy, fuel and other costs are being dealt with through the backdoor by “shrinking” the product instead of raising prices. However, hedonic adjustments are made for just this sort of thing. The CPI isn’t hoodwinked by food industry tricks. Reducing chip bags from 12 ounces to 10 ounces but charging the same price is a straightforward example of a situation that would require a hedonic quality adjustment. Using hedonics, the Bureau of Labor Statistics (BLS) would make a quality adjustment to CPI that would count the switch from 12 ounce to 10 ounce bags (while keeping the price of the bag of chips the same) as a price increase. That’s a very good use of hedonics, in my opinion.
As would be expected, supporters of hedonic quality adjustments say that the BLS uses “objective” methods wherever possible. Critics say that the entire quality-adjustment process leaves too much room for subjective judgment and is, therefore, subject to manipulation.
I am concerned about hedonic adjustments except in straightforward situations where the methodology is very objective, such as in the case of the bag of chips previously mentioned. I am uncomfortable with hedonic adjustments in the area of technology because those areas are so subjective. Take cell phones, for example. If a cell phone cost $100 two years ago but now costs $120, hedonics might say that the price didn’t actually change because the current model offers so many more features. In other words, you are paying more — but you are getting more — so you are actually paying the same. Get it? The problem is: I don’t want features! I just want the darn thing to ring. I also want to be able to call people and have voicemail. That’s all I need. That’s all most people need. I don’t want to take pictures or play games or do anything else with my cell phone except use it in a utilitarian fashion. To me personally, the price of the cell phone has indeed increased $20 because I’m not getting any value out of the added features.
The BLS might argue that if a new product offers improvements that are valuable to consumers that it would be inappropriate to ignore these improvements because some people did not value those improvements. I would argue that the BLS cannot differentiate between improvements that consumers value and those that they do not value without making subjective judgments. I would further argue that the BLS should not be making subjective judgments to calculate inflation.
It appears to me that product improvements are being pushed on Americans. If your computer is 20% faster but you only use email and word processing, have you really gotten more? We are getting enhancements that we do not want or need because the improvements cost next to nothing to the manufacturers. If you are in the cell phone business, you have a cost to buy the chip that makes the phone run. However, it doesn’t cost much to have a programmer add a few games and gizmos. The cost of the chip is the same, after all. In essence, companies can “push” these new features on consumers who place little or no value on the improvements simply because the new features add little or nothing to the product cost. The temptation is there to make quality adjustments on goods that possess features and improvements that are not really valued by consumers. If a cell phone sells for $120 that used to sell for $100, a quality adjustment could be made on the basis that the cell phone had $20 worth of extra features. However, if consumers don’t really value those extra features, inflation has just been understated by $20.
There is definitely some logic to hedonics. However, there are pitfalls too. My concern is that hedonics will be taken too far. The BLS website says, “Research is underway which considers the use of hedonic methods for quality adjustment for personal computers, televisions, VCRs, and even college textbooks ….” [Emphasis] The idea that hedonics would be applied to college textbooks is outlandish. Are they going to try to say that a chemistry textbook published this year is so much different from one published last year that a quality adjustment needs to be made? I think using hedonics applied to college textbooks is stepping over the line. I suspect that the use of hedonics by the BLS is often in violation of common sense.
Stay tuned for part 6 - the final installment of the Understanding Inflation series.
by Wade Young
Read »
