Handbook on Hedonic Indexes and Quality Adjustments in Price Indexes: Special Application to ...

254 Pages·2004·1.62 MB·English

Unclassified DSTI/DOC(2004)9

Organisation de Coopération et de Développement Economiques
Organisation for Economic Co-operation and Development 08-Oct-2004
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_ ____________ English text only
DIRECTORATE FOR SCIENCE, TECHNOLOGY AND INDUSTRY

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HANDBOOK ON HEDONIC INDEXES AND QUALITY ADJUSTMENTS IN PRICE INDEXES:
SPECIAL APPLICATION TO INFORMATION TECHNOLOGY PRODUCTS

STI WORKING PAPER 2004/9
Statistical Analysis of Science, Technology and Industry

Jack Triplett

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DSTI/DOC(2004)9

STI Working Paper Series
The Working Paper series of the OECD Directorate for Science, Technology and Industry is designed
to make available to a wider readership selected studies prepared by staff in the Directorate or by outside
consultants working on OECD projects. The papers included in the series cover a broad range of issues, of
both a technical and policy-analytical nature, in the areas of work of the DSTI. The Working Papers are
generally available only in their original language – English or French – with a summary in the other.
Comments on the papers are invited, and should be sent to the Directorate for Science, Technology
and Industry, OECD, 2 rue André-Pascal, 75775 Paris Cedex 16, France.
The opinions expressed in these papers are the sole responsibility of the author(s) and do not
necessarily reflect those of the OECD or of the governments of its member countries.

http://www.oecd.org/sti/working-papers

Copyright OECD, 2004
Applications for permission to reproduce or translate all or part of this material should be made to:
OECD Publications, 2 rue André-Pascal, 75775 Paris, Cedex 16, France.
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TABLE OF CONTENTS
BACKGROUND............................................................................................................................................8
A. OECD initiative................................................................................................................................8
B. Related work by Eurostat.................................................................................................................8
CHAPTER I INTRODUCTION....................................................................................................................9
Relevance of quality adjustment for ICT products; potential impact of mismeasurement on international
productivity comparisons; and purpose and outline of the volume.............................................................9
Acknowledgements...................................................................................................................................11
CHAPTER II QUALITY ADJUSTMENTS IN CONVENTIONAL PRICE INDEX METHODOLOGIES12
A. Prologue: conventional price index methodology..........................................................................12
B. The inside-the-sample quality problem..........................................................................................15
C. Matched model methods: overlapping link....................................................................................18
D. Matched model methods: methods used in practice.......................................................................20
1. Direct comparison method........................................................................................................21
2. The link-to-show-no-price-change method...............................................................................23
3. The deletion, or imputed price change–implicit quality adjustment (IP-IQ), method..............24
a. The BLS “class mean” method.................................................................................................25
b. Evaluation of the deletion (IP-IQ) method...............................................................................26
c. Final comments on the deletion (IP-IQ) method......................................................................29
4. Summary: four matched model methods..................................................................................29
5. Other methods...........................................................................................................................30
a. Package size adjustments..........................................................................................................30
b. Options made standard..............................................................................................................31
c. Judgemental quality adjustments..............................................................................................32
d. Production cost quality adjustments.........................................................................................32
E. Conclusions to Chapter II...............................................................................................................33
CHAPTER III HEDONIC PRICE INDEXES AND HEDONIC QUALITY ADJUSTMENTS................41
A. Hedonic functions: a brief overview..............................................................................................42
B. Using the hedonic function to estimate a price for a computer......................................................43
1. Estimating prices for computers that were available and for those that were not.....................43
2. Estimating price premiums for improved computers................................................................45
3. Residuals...................................................................................................................................46
C. Hedonic price indexes....................................................................................................................47
1. The time dummy variable method............................................................................................48
a. The method explained...............................................................................................................48
b. The index number formula for the dummy variable index.......................................................51
c. Comparing the dummy variable index and the matched model index: no item replacement...53
d. Comparing the dummy variable index and the matched model index: with item replacements54
e. Concluding remarks on the dummy variable method...............................................................55
2. The characteristics price index method.....................................................................................56
a. The index..................................................................................................................................56
b. Applications..............................................................................................................................59
c. Comparing time dummy variable and characteristics price index methods..............................60
d. Concluding remarks on the characteristics price index method................................................64
3. The hedonic price imputation method......................................................................................65
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a. Motivation.................................................................................................................................65
b. The imputation and the index...................................................................................................66
c. A double imputation proposal...................................................................................................70
4. The hedonic quality adjustment method...................................................................................74
a. The method explained...............................................................................................................75
b. Diagrammatic illustration.........................................................................................................76
c. Empirical comparisons with conventional methods.................................................................77
d. Criticism of the hedonic quality adjustment method and comparison with hedonic imputation
method................................................................................................................................................78
D. The hedonic index when there are new characteristics..................................................................84
E. Research hedonic indexes...............................................................................................................85
F. Conclusions: hedonic price indexes...............................................................................................86
APPENDIX A TO CHAPTER III HISTORICAL NOTE...........................................................................87
APPENDIX B FOR CHAPTER III HEDONIC QUALITY ADJUSTMENTS AND THE OVERLAPPING
LINK METHOD...........................................................................................................................................90
CHAPTER IV WHEN DO HEDONIC AND MATCHED MODEL INDEXES GIVE DIFFERENT
RESULTS? AND WHY?..........................................................................................................................105
A. Inside-the-sample forced replacements and outside-the-sample quality change..........................105
B. Fixed samples and price changes outside the sample...................................................................107
1. Research studies......................................................................................................................107
2. Hedonic and FR&R indexes...................................................................................................110
C. Price changes outside FR&R samples..........................................................................................110
1. Case one..................................................................................................................................111
2. Case two..................................................................................................................................112
3. Case three................................................................................................................................112
D. Empirical studies..........................................................................................................................114
1. Early studies: research hedonic indexes and statistical agency matched model indexes........114
2. Same database studies: hedonic indexes and matched model indexes....................................115
3. Analysis..................................................................................................................................118
E. Market exits..................................................................................................................................120
F. Summary and conclusion.............................................................................................................120
1. Three price effects...................................................................................................................121
2. Price measurement implications: FR&R and hedonic indexes...............................................122
a. Effectiveness...........................................................................................................................122
b. Cost.........................................................................................................................................123
APPENDIX TO CHAPTER IV A MATCHED MODEL INDEX AND A NON-HEDONIC
REGRESSION INDEX..............................................................................................................................125
CHAPTER V PRINCIPLES FOR ESTIMATING A HEDONIC FUNCTION: CHOOSING THE
VARIABLES..............................................................................................................................................136
A. Introduction: best practice............................................................................................................136
B. Interpreting hedonic functions: variables and coefficients...........................................................137
1. Interpreting the variables in hedonic functions.......................................................................137
2. Interpreting the coefficients in a hedonic function: economic interpretation.........................138
3. Interpretation of regression coefficients: statistical interpretation..........................................139
C. A case study: variables in computer hedonic functions...............................................................140
1. A bit of history: where did those computer characteristics come from?.................................140
2. Variables in mainframe computer equipment studies: connection with PCs..........................141
3. Mainframe and PC computer components and characteristics...............................................142
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4. Computer “boxes”, computer centres and personal computers..............................................144
D. Adequacy of the variable specifications in computer studies.......................................................146
1. Comprehensiveness of performance variables for PCs: the Dell data....................................146
2. Benchmark measures of computer performance.....................................................................147
a. What is a computer benchmark?.............................................................................................148
b. Proxy variables and proper characteristics measures..............................................................149
c. Discussion...............................................................................................................................149
d. Empirical implications............................................................................................................150
E. Specification problems in hedonic functions: omitted variables..................................................150
1. The uncorrelated case.............................................................................................................151
a. The hedonic coefficients (uncorrelated case)..........................................................................151
b. The hedonic index (uncorrelated case)...................................................................................151
2. The correlated cases................................................................................................................153
a. The hedonic coefficients (correlated case)..............................................................................153
b. The hedonic index (correlated case).......................................................................................155
F. Interpreting the coefficients – again.............................................................................................158
G. Specification problems in hedonic functions: proxy variables.....................................................159
H. Choosing characteristics: some objections and misconceptions..................................................161
1. Is the choice of characteristics subjective?.............................................................................161
2. The choice of characteristics should be based on economic theory........................................161
3. No-one can know the characteristics......................................................................................162
CHAPTER VI ESTIMATING HEDONIC FUNCTIONS: OTHER RESEARCH ISSUES.....................172
A. Introduction..................................................................................................................................172
B. Multicollinearity...........................................................................................................................172
1. Sources of multicollinearity....................................................................................................173
a. Multicollinearity in the universe.............................................................................................173
b. Multicollinearity in the sample...............................................................................................174
c. Conclusion: sources and consequences of multicollinearity...................................................176
2. Detecting multicollinearity.....................................................................................................176
3. Multicollinearity and data errors.............................................................................................177
4. Interpreting coefficients in the presence of multicollinearity.................................................178
5. Multicollinearity in hedonic functions: assessment................................................................179
C. What functional forms should be considered?.............................................................................180
1. Functional forms in hedonic studies.......................................................................................180
2. Hedonic contours....................................................................................................................180
3. Choosing among functional forms..........................................................................................181
4. Theory and hedonic functional forms.....................................................................................182
5. Hedonic functional form and index formula...........................................................................186
6. Functional form and heteroscedasticity..................................................................................186
7. Non-smooth hedonic functional forms...................................................................................187
8. Conclusion on hedonic functional forms................................................................................188
9. A caveat: functional form for quality adjustment...................................................................188
D. To weight or not to weight?..........................................................................................................189
1. We want a weighted hedonic function because we want a weighted hedonic index number.190
2. Do we want sales weighted hedonic coefficients?..................................................................190
a. Low sales weights: first illustration........................................................................................191
b. Low sales weights: a second illustration.................................................................................191
c. Discussion...............................................................................................................................192
d. Hedonic estimates of implicit prices for characteristics.........................................................192
3. Econometric issues..................................................................................................................193
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4. Conclusion on weighting hedonic functions: research procedures.........................................193
E. CPI vs PPI hedonic functions.......................................................................................................194
1. Do hedonic functions measure resource cost or user value?...................................................194
2. Can hedonic functions from producers’ price data be used for the CPI?................................196
CHAPTER VII SOME OBJECTIONS TO HEDONIC INDEXES..........................................................208
A. The criticism that hedonic indexes fall too fast............................................................................209
1. General statements..................................................................................................................209
2. Computer price indexes fall too fast.......................................................................................209
a. The price indexes....................................................................................................................210
b. Plausibility..............................................................................................................................210
3. Summary.................................................................................................................................214
B. Technical criticisms of hedonic indexes.......................................................................................215
1. General criticisms...................................................................................................................215
a. Functional form.......................................................................................................................215
b. Transparency and reducibility.................................................................................................215
2. The CNSTAT panel report......................................................................................................217
THEORETICAL APPENDIX: THEORY OF HEDONIC FUNCTIONS AND HEDONIC INDEXES.223
A. Hedonic functions.........................................................................................................................223
1. The buyer, or user, side...........................................................................................................226
2. Forming measures of “quality”...............................................................................................228
3. The production side.................................................................................................................229
4. Special cases...........................................................................................................................230
a. Identical buyers.......................................................................................................................230
b. Identical Sellers.......................................................................................................................231
c. Identical buyers and sellers.....................................................................................................231
d. Conclusion: functional forms for hedonic functions...............................................................231
B. Hedonic indexes...........................................................................................................................232
1. The exact characteristics-space index.....................................................................................233
a. The characteristics-space exact index: overall........................................................................233
b. The exact characteristics price index: subindexes for computers and other products............234
2. Information requirements........................................................................................................234
3. Bounds and approximation: empirical hedonic price indexes................................................235
4. Conclusion: exact characteristics-space indexes.....................................................................235
C. Recent developments....................................................................................................................236
1. The identification problem......................................................................................................236
2. The problem with estimating smooth hedonic contours.........................................................237
REFERENCES...........................................................................................................................................240

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HANDBOOK ON HEDONIC INDEXES AND QUALITY ADJUSTMENTS IN PRICE INDEXES:
SPECIAL APPLICATION TO INFORMATION TECHNOLOGY PRODUCTS
Jack E. Triplett
Brookings Institution
Washington, DC
Abstract

This handbook reviews the methods employed in price indexes to adjust for quality change: “conventional”
quality adjustment methods, which are explained in Chapter II, and hedonic price indexes (Chapter III).
Hedonic indexes have a prominent place in price indexes for information and communication technology
(ICT) products in several OECD countries, and are also used for measuring prices for some other goods
and services, notably housing. The handbook’s objective is to contribute to a better understanding of the
merits and shortcomings of conventional and hedonic methods, and to provide an analytic basis for
choosing among them.
This handbook compares and contrasts the logic and statistical properties of hedonic methods and
conventional methods and the results of employing them in different circumstances. In Chapter IV, it
reviews empirical evidence on the difference that alternative methods make in practice, and offers an
evaluation framework for determining which is better. In Chapters III, V, and VI, the handbook sets out
principles for “best practice” hedonic indexes. These principles are drawn from experience with hedonic
studies on a wide variety of products. Although most of the examples in the handbook are drawn from ICT
products, the principles in it are very general and apply as well to price indexes for non-ICT products that
experience rapid quality change, and also to price indexes for services, which are affected by quality
changes fully as much as price indexes for goods, though sometimes that has not been recognised
sufficiently.
Some objections that have been raised to hedonic indexes are presented and analysed in Chapter VII. An
appendix discusses issues of price index theory that apply to quality change, and presents the economic
theory of hedonic functions and hedonic price indexes.
The handbook brings together material that is now scattered in a wide number of places, but goes beyond
the economic literature in significant respects. The handbook has been written because there is a
widespread view that the principles for conducting hedonic investigations are not written down fully
anywhere. Research practices have just coalesced from procedures used by the most rigorous researchers.
They are not therefore readily assembled for statistical agency work which is the primary audience of the
handbook, although researchers involved in empirical work in areas such as productivity, innovation and
technological or structural change will also benefit from the discussion of methods, theory and its
application to ICT.
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BACKGROUND
A. OECD initiative
Over the past years, the Statistical Working Party of the OECD Industry Committee has dealt with
several different aspects of productivity measurement and analysis. One of these issues was the impact of
using different price indices for constructing volume output measurements of information and
communication (ICT) industries. At the international level, there are different approaches in this field,
often leading to widely diverging profiles of ICT price indices. As a consequence, international
comparability of trends in volume output measures of certain industries but also volume measures of final
demand components can be hampered. As there exists no concise source of information to assess and
compare the different approaches and to bring together the advantages and inconveniences associated with
each of them, the Working Party launched a project [DSTI/EAS/IND/SWP(98)4] for a handbook on ICT
deflators.
The Working Party identified as main objectives of the handbook to:
• Provide an accessible guide to the different approaches towards constructing ICT deflators, to
permit officials involved in producing and using such series making informed choices.
• Discuss, in particular, some of the arguments that have surrounded the construction and use of
hedonic methods in deriving price indices and compare them with more traditional practices.
• Improve international harmonisation by increasing transparency about different countries
practices in this field and by providing methodological guidance for new work.
To advance work in a relatively specialised area, the Secretariat set up a small steering group of
experts. This steering group has so far met twice (19 November 1999 and 22 June 2000) to discuss
consecutive drafts of chapters 1-4 of the handbook, prepared by Mr. Jack Triplett (Brookings Institution),
consultant to the OECD. The present document presents the revised version, in which the chapters are
reorganised and expanded, and a theoretical appendix has been added.
B. Related work by Eurostat
In 1999, Eurostat launched several Taskforces to investigate into price and volume measures of
different parts of National Accounts. One of these taskforces reviewed price and volume measures for
computers and software. This review of current practices revealed a large variety of quality adjustment
procedures in European countries. Different practices were assessed and preferred methods identified,
among them the hedonic approach. Subsequently, Eurostat established the European Hedonic Centre to
explore the question of hedonic indexes for countries of the European Community.
OECD and Eurostat work are highly complementary: whereas the Eurostat Task Force undertook a
broad review of the issue with a view to recommending certain methods and to advise against others, the
OECD Handbook aims at significantly more detail in its theoretical and practical detail of the issue of
quality adjustment and the construction of hedonic price indices. There has been close interaction between
the OECD and the Eurostat so as to ensure complementarity and to avoid duplication. Additionally,
Mr. Triplett, the author of this document, was involved in the European Hedonic Centre, which provided
another link.
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CHAPTER I

INTRODUCTION
Relevance of quality adjustment for ICT products; potential impact of mismeasurement on
international productivity comparisons; and purpose and outline of the volume
Deflators for real output, real input, and real investment – for producing productivity measures or
value added in national accounts – are derived primarily from price indexes estimated by statistical
agencies. Whether the deflators are consumer (retail) price indexes (CPI or RPI) or producer (wholesale)
price indexes (PPI or WPI), quality change has long been recognised as perhaps the most serious
measurement problem in estimating price indexes (among the many possible references are: Hofsten, 1952;
Stone, 1956; Price Statistics Review (Stigler) Committee, 1961; Nicholson, 1967; Griliches, 1971; Boskin
Commission, 1996; Eurostat, 1999).
In national accounts, any error in the deflators creates an exactly equivalent error of opposite sign in
the real output, real input, real investment and real consumption measures (which are hereafter referred to
as “quantity indexes”1). For this reason, discussing the problems posed by quality change in price indexes
is the same thing as discussing the problems of quality change in quantity indexes, and therefore in
measures of productivity change as well.
There is tremendous interest in understanding the contribution of ICT products to economic growth
and to measures of labour productivity (see, for example, Schreyer, 2001). These are products that show
very rapid rates of quality change, and accordingly they throw the quality adjustment problem in price
indexes into high relief.
Different quality adjustment methodologies are employed for ICT products across OECD countries,
and they seemingly make large differences in the trends of price movements for these products. Wyckoff
(1995) reported that changes in computer equipment deflators among OECD countries ranged from plus
80% to minus 72% for the decade of the 1980s; the largest decline occurred in the US hedonic price
indexes for computer equipment.
A Eurostat Task Force (Eurostat, 1999), reviewing ICT indexes for the early 1990s, found a smaller
dispersion among European countries’ ICT deflators. But still, price declines recorded by national
computer deflators in Europe ranged from 10% to 47%, and again, the largest price decline was recorded
by a hedonic price index (France). The Task Force calculated that price variation in this range could affect
GDP growth rates by as much as 0.2%-0.3% per year, depending on the size of a country’s ICT sector.
International comparisons of productivity growth would be affected by approximately the same magnitude.
If different quality adjustment procedures among OECD countries make the data noncomparable, then
the measured growth of ICT investment and of ICT capital stocks will not be comparable across OECD

1. The 1993 System of National Accounts (Commission of the European Communities et al., 1993) uses the
term “volume indexes”. However, in both the index number literature and in normal English language
usage in economics, quantity index is the preferred term, so this handbook follows general usage, rather
than the specialized language that has developed in national accounts.
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countries. Data noncomparability for ICT deflators, investment and capital stocks therefore creates serious
limitations to making international comparisons of economic growth and understanding international
differences in productivity trends and levels and sources of growth. And when ICT data are not
internationally comparable, estimates of the impact of ICT on economic growth in different OECD
countries will have limited, if any, meaningfulness.
As the Wyckoff (1995) and Eurostat (1999) studies suggest, hedonic price indexes show rapidly
declining ICT prices in most countries in which they have been estimated. Conventional methodologies for
adjusting for quality change generally yield smaller price declines for ICT products; in some countries
conventional methodologies have even produced rising ICT price indexes in the past.
This handbook reviews the methods employed in price indexes to adjust for quality change. A natural
division is between “conventional” methods typically employed by the statistical agencies of many OECD
countries, which are discussed in Chapter II, and hedonic methods for adjusting for quality change
(alternatively known as hedonic price indexes). The latter have a prominent place in price indexes for ICT
products in several OECD countries. Hedonic methods for producing quality-adjusted price indexes are
reviewed in Chapter III.
The handbook brings together material that is now scattered in a wide number of places, but goes
beyond the economic literature in significant respects, particularly in the comparison of conventional and
hedonic methods in Chapter IV. This handbook compares and contrasts the logic of hedonic methods and
conventional methods and the results of employing them in different circumstances. Although most of the
examples in the handbook are drawn from ICT products, the principles in it are very general and apply as
well to price indexes for non-ICT products that experience rapid quality change, and also to price indexes
for services, which are affected by quality changes fully as much as price indexes for goods, though
sometimes that has not sufficiently been recognised.
The handbook sets out principles for “best practice” hedonic indexes (in Chapters III, V, and VI).
These principles are drawn from experience with hedonic studies on a wide variety of products. The
handbook has been written because there is a widespread view that the principles for conducting hedonic
investigations are not written down fully anywhere, partly because they have just coalesced from
procedures used by the most rigorous researchers. They are not therefore readily assembled for statistical
agency work. Again, the best practice examples in this handbook are drawn primarily from research on
ICT equipment, but they apply as well to hedonic investigations of all products, and not just ICT products.
For example, there is a huge literature on hedonic functions and hedonic price indexes in housing markets,
both rental units and the house prices themselves. Though the examples in the handbook were drawn from
ICT products, not primarily from housing markets, the analysis and the principles apply to housing market
hedonic functions.
Chapter VII considers some objections that have been raised to hedonic indexes. An appendix
discusses some issues of price index theory and applications to hedonic price indexes; though much of
what is written in the manual depends on the theory, this material is placed at the end as a reference
document, in order to make the operational parts of the manual more accessible.
With respect to statistical agencies in OECD countries, the handbook is descriptive, not prescriptive,
and in this sense its purpose differs from, for example, the System of National Accounts (Commission of
the European Communities et al., 1993). For the professional audience, the handbook contributes to a
better understanding of the merits and shortcomings of conventional quality adjustment methods and of
hedonic price indexes. The best practice principles developed in Chapters V and VI supplement other
sources, such as the chapter on hedonic indexes in the empirically-oriented econometrics textbook by
Berndt (1991).
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