Challenges in Economic Statistics: Price Indices Seminar

Price Statistics Seminar on challenges in economic statistics Tehran, IranNovember 2008 Presentation by Carsten Boldsen Hansen, UNECE (carsten.hansen@unece.org)

Overview • Main types of price indices • Construction of price indices • Calculation of elementary indices • Missing prices, seasonal products and quality changes • Basic CPI concepts and measures • International recommendations • Future challenges for CPI

1. Main types of price indices • Consumer price indices • Producer price indices • Export and import price indices • Sectoral price indices

1. Main types of price indices Consumer price indices (CPI) • Measure of average price change on goods and services acquired by the households for consumption • Used for different purposes: • Measure of general inflation • Compensation – i.e. indexation of wages, pensions, income transfers • Indexation of contracts • Deflation of other economic statistics • Attracts broad interest from many user groups

1. Main types of price indices Producer price indices (PPI) • Output PPIs measure the price change on products (goods and services) sold by the production sector • Input PPIs measure the price change on products acquired as intermediate input by the production sector • Used for different purposes: • Measure of inflation in the production sector • Indexation of contracts • Deflation of other economic statistics

1. Main types of price indices Export and import price indices (XMPI) • XPI measures price change on products produced for export • MPI measures price change on imported products • Used for different purposes: • Measure of inflation in the production sector • Indexation of contracts • Deflation of other economic statistics

1. Main types of price indices Sectoral price indices (XMPI) • Building and construction price indices • Agriculture, forestry and fishing • Used for different purposes: • Measure of inflation in the production sector • Indexation of contracts • Deflation of other economic statistics

2. The construction of price indices CPIs, PPIs and XMPIs are calculated in two stages: 1. Elementary aggregate indices Calculated on basis of a sample of prices for individual products (and perhaps individual price weights) 2. Higher-level indices Calculated as weighted averages of elementary aggregate indices using the value shares as weights

2. The construction of price indices The typical aggregation structure

3. Calculation of elementary indices Elementary indices should consist of: • Products – goods or services – that are as similar as possible, i.e. homogeneous • Products with similar price movements; minimize the expected dispersion of price movements There are 3 main formulas for calculation of elementary indices …

3. Calculation of elementary price indices Carli index – the arithmetic mean of the price ratios Dutot index – the ratio of arithmetic mean prices

3. Calculation of elementary price indices Jevons index – the geometric mean of the price ratios = the ratio of geometric mean prices

3. Calculation of elementary price indices Exercise 1: Calculation of elementary index a) Calculate the Carli, Dutot and Jevons indices! b) Explain and give an interpretation of the results. c) What are the main advantages/disadvantages of the 3 indices? d) Which index formula is used for your CPI and PPI?

3. Calculation of elementary price indices

3. Calculation of elementary price indices How to decide which index formula to use? Select a number of tests – or axioms – that the index should meet. More important tests are: Proportionality:If all prices change x%, the index should also change by x% Commensurability: The index should be invariant compared to the unit in which prices are recorded Time reversal: The index from period 0 to period t should equal the reciprocal of the index from t to 0 Transitivity: The index from 0 to 1 multiplied (chained) by an index from 1 to 2 should equal a direct index from 0 to 2.

3. Calculation of elementary price indices • Carli fails last two – time reversal and transitivity • Dutot fails commensurability • Jevons passes all four • Jevons recommended as the preferred index in general

3. Calculation of elementary price indices Chained or direct elementary aggregate indices? • A direct index compares the prices of the current month with those of a fixed reference month • A chained index compares month-to-month price changes and multiplies the monthly indices into long-term price indices • Chained and direct index give same results for Dutot and Jevons. A Chained Carli is upward biased – should not be used! • Monthly chained indices appear to have some practical advantages in the treatment of missing prices and imputations

4. Missing prices, seasonal products and quality change Missing price observations • When in some month(s) it is not possible to collect a price for a product included in the sample Seasonal products • Products included in the sample that disappear for a period so that prices cannot be collected in all 12 months of the year Quality changes • Changes in product quality over time should be adjusted for so that the price index shows only pure price changes

4. Missing prices Exercise 2: • Missing prices, seasonal products and quality changes are regular problems in price index compilation • Use of inappropriate methods may lead to serious bias in the price index a) What are the main problems associated with missing prices, seasonal products and quality changes? b) What can your price statistics division do to deal with these problems?

4. Missing prices Temporarily missing observations: • Omit the item for which the price is missing so that a matched sample is maintained, even though the sample is depleted. • Carry forward the last observed price. • Impute the missing price by the average price change of the prices that are available in the elementary aggregate. • Impute the missing price by the price change of a comparable item. Carry forward biases CPI towards zero change. Use only if it can be justified, and only for a very limited period of time

4. Missing prices Permanently missing observations: • Where products disappear permanently, a replacement product has to be sampled and included in the index. • The replacement product should, ideally, accounts for a significant proportion of sales, is likely to continue to be sold for some time, and be representative of the market the old product covered.

4. Missing prices Permanently missing observations: Replacements without overlapping prices: • Impute price in previous period to ensure the inclusion of the replacement product does not affect the index Replacements with overlapping prices: • Involves implicit adjustment for quality difference: the relative prices of the new and old product are assumed to reflect their relative qualities. • For perfect or nearly perfect markets this may be a valid assumption, but for other markets it may not hold.

4. Seasonal products Two main approaches: • The fixed weight approach • The variable weights approach The fixed weight approach is most common in use – • in line with a fixed annual basket approach to the CPI • it is necessary to estimate a price in of-season periods

4. Seasonal products Model 1: Carry forward (a)

4. Seasonal products Model 2: Carry forward (b)

4. Seasonal products Model 3: Impute price (a)

4. Seasonal products Model 4: Impute price (b)

4. Seasonal products Conclusions: • While prices are carried forward, the monthly changes of the CPI will be biased towards zero • imputation avoids, or at least reduces, the bias of the monthly changes of the CPI • the 12 months rate of changes will be (largely) unaffected in all the four models • in the long-term, the CPI will show the correct development in all four models

4. Quality changes What is the problem with quality changes? • The CPI/PPI aims to measure the average price change of a fixed basket of products • Changes in the baskets other than price changes should not influence the index • Collected prices need be adjusted for the value of quality changes to ensure the price index is showing only real price changes

4. Quality changes Example: Quality changes of a PC

4. Quality changes HICP for computers (09.1.3), 2004 = 100

4. Quality changes • The pace of innovation is high, leading to continual changes in the quality of products • There is not much consistency among countries in the methods they use to deal with quality change • The choice of method can lead to very different results • The way in which a product is replaced by another always imply some assumption about the relative qualities of the 2 products – You cannot “do nothing”!

4. Quality changes • Direct comparison: The price of the new product is compared directly with the price of the old one. Assumption: the 2 are of similar quality and the whole price change is included in the index • “Link to show no change”: The price of the new item is linked into the index. The price change is assumed to equal the quality change and thus not included in the index calculation • Overlapping prices: With overlapping prices the new item can be linked into the index. This assumes that the price difference reflects the value of any quality difference between the two items

4. Quality changes • Matched models only. Only those products for which a price is recorded in both the current and the reference period are included in the calculation of the elementary index. This corresponds to imputation, where the price development of the new product is estimated by the average price development of those product for which matched prices have been recorded • Option prices: If the difference between A and C is the inclusion of an extra option, e.g. a CD-ROM drive in a computer, the extra option can be separately priced and appropriate adjustment made in the recorded price

4. Quality changes • Production costs: Producers can be asked about the difference in cost of producing the old and new item, and the ratio of costs be applied for adjusting the prices • Experts judgement: Persons with detailed product knowledge value the difference between the new and old product, and appropriate adjustment are made in the recorded prices • Hedonic adjustments by use of hedonic regression. Resource and data demanding

4. Quality changes The Handbook on price and volume measures in national accounts (Eurostat 2001)divides QA methods into 3 groups: • A methods: most appropriate methods • B methods: those methods, which can be used in case an A method cannot be applied • C methods: those methods, which shall not be used Follows a case-by-case approach • The Handbook provides useful guidance and numerous practical examples. It is available from Eurostat’s webpage

4. Quality changes Some recommendations: • Agree on which methods to use on a case-by-case basis • A mix of simple, implicit methods usually gives good results – the practice in most countries • Produce guidelines to staff/price collectors • Do not apply “link to show no change” as default • Be transparent - document methods

5. Basic CPI concepts and measures • The main purpose(s) of the CPI A measure of inflation or cost of living – or both? • Geographical and population coverage The national concept: covers the consumption expenditure of resident households, whether made in the country or abroad The domestic concept: covers the consumption expenditure inside the country, whether made by resident or foreign households - weighting data may need be adjusted/supplemented! • The price concept Purchaser prices - the prices that the household actually pay for goods and services, including taxes less subsidies

5. Basic CPI concepts and measures Practical differences in targeting an inflation index or a COLI

6. International recommendations • The CPI Manual in English/Russian is available from ILO on www.ilo.org/public/english/bureau/stat/guides/cpi/index.htm • Supplementary Handbook: Practical Guide to Compiling Consumer Price Indices. Under production. Draft available on www.unece.org/stats/documents/2008.05.cpi2.htm • Papers from Joint UNECE/ILO meetings on CPI are available on www.unece.org/stats/archive/docs.date.e.htm • Papers from meetings in the Ottawa Group on Price Indices are available from www.ottawagroup.org

7. Future Challenges • Price collection methods • Treatment of difficult products: e.g. housing, computers, cars, services, telecommunication, health care • Optimization of the sample • Automatic Statistical data editing • Dissemination

Challenges in Economic Statistics: Price Indices Seminar