Heinz is right, productivity is overstated due to hedonic pricing.. the following excerpt from Grant's makes a compelling case to this end.
One important method used in the
U.S. to compare products across time
periods is hedonic price indexing. The
idea of hedonic price indexing is this:
instead of putting a price on a particular
product, put a price on each of the products
characteristics. The prices of product
characteristics are estimated by
looking at a range of products with different
characteristics. For example, in
the case of computers, there might be a
?price of processor speed? (in dollars per
megahertz), a price of the IBM brand
name, and so on. These hedonic
prices can then be used to generate a
theoretical price for any product
whose characteristics are known.
Government statisticians generate theoretical
prices for this year's products
using last year's hedonic prices, and
they compare these theoretical prices
with the actual prices observed this
year.
Currently, it is used with housing, semiconductors,
cell phones, digital switches, import
and export items, and, most notably,
computer hardware and software.
These last two categories are particularly
important because they have
come to represent the most important
factor in the growth of investment,
which is the most volatile component
of gross domestic product.
?Today, for example, the cost incre-ment
between a system with a 600
MHz Pentium III and an identical sys-tem
with a 700 MHz Pentium III can be
as little as $70 (70 cents per MHz). Yet
the cost increment from 733 MHz to
800 MHz can be as much as $200 ($3
per MHz). And it can cost nearly $800
($6 per MHz) to go from 866 MHz to 1
gigahertz (1,000 MHz). The recent
introduction of the 1GHz chip is push-ing
down prices near the high end, but
people who get along fine with 600
MHz?people who use computers for
business rather than rocket science?
won?t see much price benefit. Typical
hedonic models really do give a single
price for processor speed in dollars per
MHz, and when they price processor
speed, they price the marketing man-ager?s
computer along with that of the
rocket scientist.
?In this situation, a hedonic regres-sion
will estimate the ?hedonic price of
processor speed? as some kind of com-promise
between the $6 high end and
the 70 cents (or less) low end. Let?s say
$3. When this figure is applied across
the board to produce theoretical prices,
the theoretical price for the high-end or
low-end machine will tend to underes-timate
the actual price, whereas the the-oretical
price for a mid-range machine
will tend to overestimate the actual
First, while the validity of the tech-nique
depends on having the right set
of hedonic pricing characteristics, the
choice of characteristics is essentially a
subjective one. Second, the technique
is not well suited to discontinuous
technological change: It relies on the
premises that this year?s goods and last
year?s goods can be described in terms
of the same characteristics and that the
characteristics mean the same thing
this year as they did last year. In a
world of dramatic innovation, rapid
obsolescence and compatibility con-straints,
the applicability of the hedo-nic
price concept is dubious. Finally,
hedonic pricing depends on specifying
in a simple mathematical form the way
each characteristic should affect the
price. That may be easy when the char-acteristic
is something, like computer
memory, that can be added or removed
from a product, and might simply cost
a certain number of dollars per
megabyte. But when the characteristic
is something abstract, like processor
speed, a simple mathematical relation-ship
is likely to be misleading.
?To see how hedonic pricing can lead
to distortions, consider the way in which
the rise in processor speed occurs. Chip-makers
are constantly introducing new
processors that are marginally faster
than the fastest previously available.
The cost increment for the newest,
fastest processor over the previous
model is generally substantial, and the
price of the old best falls when a new
price. The theoretical price of a 1GHz
machine selling at $2,700 might be
more like $2,550, but the theoretical
price of a 733 MHz machine selling at
$1,600 might be more like $1,750.
?Now what will happen if Intel
introduces a new Pentium III that runs
at 1.1 GHz (1,100 MHz)? The cost of a
1 GHz computer will fall by several
hundred dollars?but most people
won?t care. The cost of a 600 MHz com-puter
will change little. The cost of a
733 MHz computer will fall by maybe
$70, a small change in dollar terms, but
enough to make it economical for main-stream
purchasers, since they can now
get more power (compared to, say, a
a negligible cost
increment. So, when the government
collects its data, it will find many peo-ple
buying computers around the 733
MHz range. And let?s say they pay
around $1,530 for the machine that
used to cost $1,600. It used to cost
$1,600, but its theoretical price was
$1,750, so the $70 price drop looks like
a $220 price drop. This will be partly
offset by the reverse effect at the high
end?1GHz computers whose theoret-ical
price was understated?but since
that?s a smaller market, the aggregate
effect will be smaller. And as for the old
low-end computers, which also had
understated theoretical prices, they
won?t be selling any more. The net
effect is that it looks like computer
prices in general have fallen signifi-cantly,
when in fact the only large drops
have been at the high end.
?So what effect does this scenario
have on the statistics? For one thing,
obviously, inflation will be understated,
because the government averages a lot
of huge price drops for computers that
really only had small price drops. The
other side of the coin is that growth will
be overstated. The new year?s economy
produces lots of 733 MHz computers,
which, in terms of last year?s theoretical
prices, are replacing (on the production
line, that is), old, low-end computers
that had been undervalued. Therefore,
real output growth, and anything
derived from it, is overstated.
Productivity appears to be growing
quickly, and anything ?real? in the
national accounts?real GDP growth,
real profit growth, real consumption
growth, etc.?is actually less real than
you might think.
?Another point worth noting in con-nection
with this example is that the
(hypothetical) new 1.1 GHz computers
will also appear to have experienced a
price drop and to be reflecting a pro-ductivity
increase, even though, really,
their price could not have dropped,
since they didn?t even exist before. In
this example, it?s true, the ?apparent
price drop? for the 1.1 GHz computer
would be understated relative to a
?perfectly fit? hedonic model. But the
fact remains, as far as the 1.1 GHz
machine is concerned, there was no
actual price drop, and there was no
increase in productivity for any actual
product: simply, a new product was
introduced. Philosophically, it?s hard
to regard this as a real increase in pro-ductivity
(unless, of course, someone
can show that these new computers
make the rest of the economy more
productive). Otherwise, wouldn?t we
have to regard every new invention as
an increase in productivity? |
