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Concepts & Tutorials

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

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:

regression2

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:

regression3

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.

I wrote about this a while back on quora:

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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  • Ranga says:

    That’s an interesting article. Thanks for sharing such wider gamut of information. Ensures regular readers keep coming more often.
    One thought:
    India might not be doing Hedonic Index / adjustments. Doesn’t the govt tweak the components of CPI/WPI to get ‘friendlier’ numbers? (not very frequently, but I remember a couple of instances in past few years).
    Please correct me if wrong:

  • Sandeep says:

    How about cars? I bought a Santro in 2003 for around 4lacs and even today an i10 (which is similar to yesterday’s Santro) costs between 4-5 lacs. So we are getting same value in cars today by paying same price what we paid 11 years ago. This means cars have actually turned cheaper. So there is no inflation in auto industry?

  • DJ says:

    An iphone would be worth a billion dollars in 1970. That alone (and there are other things like that) would counter-balance inflation in all other goods during that time, in a developed country. I think inflation is almost an obsolete concept in a developing country… all that one gets affected by is asset and healthcare inflation and perhaps, higher education inflation. In developing countries, food inflation, energy inflation is still important (in addition to asset/healthcare inflation).

  • DJ says:

    I didn’t get the entry level argument. For one, a 42 inch plasma is not entry level, and I think the argument about entry level can work the other way in other examples, like the iphone. How to compare an entry level landline phone with an entry level cell phone today when a cell phone would have cost much more few decades back. I’m suspicious of anecdotal comparisons (and even then, the main argument of entry level does not apply in the single example provided). Probably missing something myself….

    • In the US it could be entry level πŸ™‚ In fact if it’s the other way, that’s fine (because that would be deflation). But you can’t say that an iPhone 1 today would cost – let’s see – $1 – because the iPhone’s lowest model is $99 and the iPhone 1 has much fewer features. That makes no sense; the lowest iPhone available maybe one comparison if the corresponding models don’t exist!
      Basically it’s all broken – I don’t mind deflation if it’s real. But I do mind if it’s built through bad “proxy” construction. This is extremely bad application of statistics, in my opinion, to basically justify a lower number than actually exists. The simple fact is that if I went around trying to buy a new phone today it would actually be cheaper than perhaps many years ago, but that’s because of actual prices – not because the current lowest end phones have more features.

      • DJ says:

        Well, this is the BLS statement on the impact of these things:..
        http://www.bls.gov/cpi/cpiqa.htm#Question_3
        That’s not to say that I accept the BLS clarifications. ShadowStats has a counter to these BLS clarifications, if one is interested. I found the ShadowStats paper unconvincing, but people can draw their own conclusions.
        I’m not even sure if your argument that “If meat gets expensive, people will eat chicken, so let’s adjust prices lower for that” is correct, because according to the BLS link above, the substitution effect does not apply across meat categories. Although, it seems that a lot of people quote that argument, so I dunno…
        Consumer appliances like TVs and computers (where the hedonic argument is probably the most relevant, and if not, then a better example from another item might be more useful) are less than 1% of the inflation index in the US, so even if it is an issue, its overall impact may not be large. I am much more likely to believe that there is plenty of deflation in consumer/electronic appliances, and that understating inflation in this category is not a major problem regardless of statistical issues.
        It would be nice to see an unbiased overall number of how much difference it all adds up to (which the BLS claims is not much).
        Anyway, who cares what some bureaucracy says and does anyway (and that includes both the BLS and the Fed which acts on the BLS numbers)!! The real world will do what it will do, at least eventually. πŸ™‚
        I have a much more philosophical point about the effect of making GDP look higher than it is, but that is better done over a beer than in a retarded comment box…

        http://www.bloomberg.com/news/2012-04-19/cpi-conspiracy-theories-persist-even-with-broad-checks.html

        • I’m all for the beer! If you are in Bangalore…ping?
          BLS says this but I’m not sure how it works; for instance if a gas station has lower prices but it’s far away from your house would you go there? “Gasoline (unleaded, regular)” is one category, so they would be substituting, but it may not be practical to assume that. (The only way it would work is to take the weighted average)
          Wonder if the US gives up data without the adjustments (“raw”)
          Eventually you’re right – inflation expectations are just that, expectations, and they don’t rely on Fed data πŸ™‚

        • DJ says:

          That would be nice but I’m up here in Delhi. πŸ™‚ I will be sure to ping if I come down there some day…

        • And I will if I come to that part of the country πŸ™‚

  • Arpan Shah says:

    I do not believe the example quoted is a fair one.
    You will have to make changes to inflation basket to account for the most commonly consumed articles during the measuring period.
    You cannot compare a product which is no longer actively produced in the market (as in the case of an 42 inch CRT) with a mainstream TV.
    The inflated price for the 42 inch CRT is due to its scarcity rather than inflation in cost
    I am sure if you took a basket of articles from 50 years ago – and compared the price of these today – there will be a wide dispersion.
    Price of some items would have moved in a reasonable range – but for other articles which are no longer produced – no ready price may be available. A common article 50 years ago may no longer be produced & would result in a price distortion. You might have to pay 100 to 1000 times more go get that article – but that does not mean that inflation is 100 or 1000 times.
    On a side note – I used to be a regular follower of zerohedge – but nowadays it has just resorts to sensationalism. One of my biggest pet peeves – using a chart that is not scaled properly with a non-zero base – widely used nowadays in financial media to exaggerate movements – for example price of an stock moved from 100 to 101 – a 1% movement – however the chart will reflect 95 to 105 – making the 1% move look like a 10% move

    • Arpan, the funda of “Price of some items would have moved in a reasonable range – but for other articles which are no longer produced – no ready price may be available. A common article 50 years ago may no longer be produced & would result in a price distortion.” is exactly why hedonic adjustments are bad. If you can’t compare them, dn’t compare them. If you have to compare them, then choose proxies like “mainstream phones” rather than apply hedonic adjustments to features.
      Using hedonic adjustments means you apply them on everything. Including potatoes – for instance if they come wrapped in a sack now, then you could say that oh, that is a feature that didn’t exist in the past, so let’s do the hedonic adjustment for potatoes in the past to have included a sack, and voila, today’s higher price is not that much higher.
      Inflation isn’t 100x. If you can’t compare like to like, then you shouldn’t do hedonic adjustments either – there will be deflation, for sure, in some items, but hedonic adjustments just magnify them tremendously.

      • DJ says:

        Afaik, food is excluded from hedonic adjustements. Hedonic adjustments apply only to the categories listed here.
        http://www.bls.gov/cpi/cpihqaitem.htm
        If we leave out the rent category, which has a different rationale (total 30%), it applies on 3% of the index.
        OP, the example is from the official BLS website so if its not fair, then blame them…..
        http://www.bls.gov/cpi/cpihqaqanda.htm
        About Zero Hedge, I second OPs point. During the crisis, I once listened to a Goldman Sachs conference call on its earnings. Zero Hedge misreported something and I pointed it out in their comments. The comment thread was deleted by the author (no, the language was not heated or abusive). The real issue though was that they said that A was a problem, when it wasn’t, while there was a larger problem with B which they ignored. That is the problem with lazy, sensationalist media. They will spend time on Vadra shoving a mic, but they will rarely do an objective report on the corruption trail. Its still a good site for some of their data posts, but one has to tune out the sensationalism.

        • Excellent find! (on the hedonic stuff)
          Yeah, zerohedge is more sensationalist than others. But in this case, I think they’re bang on…that it’s unlikely that a CRT TV at $250 is more expensive, hedonically adjusted, than a 42 inch plasma.