Foundations

# Hedonic Adjustments For Inflation: Shady Ways To Make Things Look Good

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Here’s an interesting piece by Zero Hedge on Hedonic Adjustments – in other words, how a 400% increase in price actually becomes a 7% DECLINE in price! You start with this:

Which then gets complicated and more complicated to compare, so you do a lot of up and down adjustments and try to put the price of Item A with the price of Item B. But you forget that Item A was 2001 and Item B was 2010, and in 2010 you couldn’t get item A even if you wanted to, or you would pay an obscene price for it. When you forget that and only do the math to equate them:

Essentially you decide that in 2001 you would have paid \$1345 for what was Item B.

But consider this: if you get what is “entry level” in 2001 is different from entry level in 2010, you should be comparing the entry level prices only. You can’t get an apples-to-apples comparison; because it’s inconvenient – if you tried to buy Item A you would find that the price has gone absolutely berserk and inflation would be 6000% or something.

In Technology cost curves are parabolic. That is, if you put the configuration (from what is entry level to “high end”) on the X axis and price on the Y axis, you’ll find that less that there is an optimal cost of whatever is in vogue today. In 1998 it was 4GB hard disks, and in 2010 it was 500 GB hard disks. That’s the lowest cost. Anything with a lower than optimal will cost you more and anything that’s better than optimal will cost you more.

In parabolic cost curves, or those shaped like a U, where the U’s bottom is one configuration, the U will shift to the right in 10 years and have it’s bottom on a better configuration. What we should be comparing is the price difference between the bottom of the U’s, regardless of whether it’s better or not. Because when you buy, you’ll buy whatever’s in the market today.

The concept is: If a laptop with an 800 Mhz processor was retailing at \$700 five years ago, and today you can get a laptop with a 1.6 Ghz (1600 Mhz) for the same price, the inflation calculators say that you have received more value for the same price, therefore let’s adjust the price down, to say \$500. That means that a laptop price has actually fallen by \$200.

Sadly, if you even TRIED to get a new laptop with an 800 Mhz processor, you couldn’t. If you asked for it to be custom built, you would end up paying \$7000. Never mind; the hedonic adjustment will ignore that.

Other forms of distortion are to ignore food and energy prices in “core” inflation, and to use substitution effects (If meat gets expensive, people will eat chicken, so let’s adjust prices lower for that)

The idea of the distortion is to keep inflation low so that an unimpressive GDP growth figure suddenly becomes attractive. A 3% “nominal” growth in GDP with 4% inflation is actually negative 1% “real” growth, so perhaps it’s easier to distort inflation and make it look like 1% inflation – suddenly, you have 2% growth!

The inflation calculation, and thus, the GDP calculation is broken (in the US). In India we don’t do hedonic adjustments (I think) and I hope we never will.

But when we have to manufacture GDP growth, I’m sure our economists will have enough “evidence” that the shady adjustments work better than the painful work of actually fixing the economy. Everything can look good on an excel sheet.

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