CHAPTER 9 QUALITY CHANGE AND NEW PRODUCTS


QUALITY

9.1 The objective of the CPI is to measure pure price change over time, so ideally identical goods and services should be priced from one period to the next. This is called pricing to constant quality. However, in practice, new products appear on the market frequently and replace older products. These new products have different attributes (or quality). For price index purposes, it is necessary to measure these changes in quality, and to remove any change in price attributable purely to the change in quality from the inflationary movement in the price.

9.2 The concept of quality used in the Australian CPI is based on the notion of consumer utility. Quality change is measured by reference to the expected value to the consumer of the changes. Although it is not always possible to achieve this in practice, it is the principal guideline in making decisions about quality change.

9.3 The term quality embraces all those characteristics in a good or a service that a household values or from which it derives utility. Thus the problem is to identify those characteristics that households value, to make an estimate of the value of those characteristics, and to measure the change in those characteristics so that their effect can be removed when calculating price movements. When used in this context, quality encompasses all attributes of a product, including quantity.

9.4 Sometimes the adjustment for quality change is simple. A common case, as demonstrated in the following example, is when only the volume or weight of an item changes.

9.5 Suppose there is a price sample for medium sized tins of tomato soup from three respondents, each of which reports their most popular brand. Now suppose in the current period, the size of the can of soup sold by respondent A drops from 440g to 400g with no change in the sizes of the cans sold by the other respondents. The price data and index calculations for this elementary aggregate are shown in Table 9.1 below.

9.1 PRICE ADJUSTMENT FOR CHANGE IN QUANTITY
			Base period	Previous period	Current period
Prices
	Prices with no quality adjustment
		Respondent A	1.50	1.75	1.70
		Respondent B	1.75	2.00	2.05
		Respondent C	1.25	1.30	1.40
		Arithmetic mean	1.50	1.68	1.72
	Prices after quality adjustment
		Respondent A	1.36	1.59	1.70
		Respondent B	1.75	2.00	2.05
		Respondent C	1.25	1.30	1.40
		Arithmetic mean	1.45	1.63	1.72
Geometric mean formula
	Price relatives with no quality adjustment
		Respondent A	1.000	1.167	1.133
		Respondent B	1.000	1.143	1.171
		Respondent C	1.000	1.040	1.120
		Geometric mean	1.000	1.115	1.141
	Price relatives after quality adjustment
		Respondent A	1.000	1.167	1.247
		Respondent B	1.000	1.143	1.171
		Respondent C	1.000	1.040	1.120
		Geometric mean	1.000	1.115	1.178
Index
	With no quality adjustment		100.0	111.5	114.1
	After quality adjustment		100.0	111.5	117.8
RAP Formula
	Period to period price movment
		With no quality adjustment		12.0%	2.4%
		After quality adjustment		12.0%	5.5%
	Index
		With no quality adjustment	100.0	112.0	114.7
		After quality adjustment	100.0	112.0	118.3

9.6 If no allowance is made for the smaller can size in the current period, the price of the can from respondent A would show a fall of 2.9 per cent ((1.70 - 1.75)/1.75 x 100). What is required for the base and previous periods are the prices that would have been paid in those periods for the identical item that was priced in the current period. These are estimated by multiplying the base and previous period prices by the ratio of the current period quality (can size of 400g) to the previous period quality (can size of 440g). The result is that the geometric mean of the price relatives is 1.178 in the current period once allowance is made for the quality change, and not 1.141.

9.7 Similar adjustment procedures can be used for other quality changes, the only issue being how to determine a suitable quality measure. For example, changes in the alcoholic content of spirits could be allowed for simply by adjusting the price proportionally for the change in the alcoholic content. More difficult would be the handling of changes in the meat content of sausages or the salt content of margarine.

9.8 Of course, there are limits to the application of this approach. For example, it would be inappropriate to replace a medium sized can of tomato soup with a large or small sized can since price typically falls per unit of weight with significant increases in the container size. Rather, different elementary aggregates should exist for any significantly different container sizes.

9.9 The situation becomes more complicated when there are technical changes to goods. Consider an improvement in the fuel economy of a motor vehicle brought about by, say, some modification to the engine. If there were no other changes in the vehicle (its power, speed capabilities etc.), then an estimate could be made of the fuel savings that would accrue over the effective life of the vehicle, and the vehicle’s price adjusted accordingly. It is implicitly assumed that the household values the saving of $1 in fuel cost as much as they do $1 of income.

9.10 In some cases, there may be overlapping prices for the item with the quality change, and the item it replaces. For example, suppose in period t there are price observations on a standard resolution TV that is included in the TV price sample, and a comparable TV with a higher screen resolution. The standard resolution TV ceases to be available in period t+1. Suppose the price observations are as follows:

Item	Period t	Period t+1
Standard resolution TV	$400	n.a.
High resolution TV	$500	$550

9.11 A price for the standard TV in the price sample in period t+1 can be imputed by using the price movement of the high resolution TV, that is $440 ($400 × 550/500). This approach relies on an assumption that the difference in price between the standard and high resolution TVs in Period t is due entirely to quality differences. The price change between periods t and t+1 for the high resolution model can then be assumed to represent the price movement that would have occurred if the standard resolution model had been available for pricing.

9.12 This approach to quality adjustment is suitable so long as the price difference between the TVs in period t is representative of the difference in utility households derive from the two TVs. This could be expected in a competitive market and where the better feature has been available for some time. It would not be appropriate if the price of the item, which is phased out in period t+1, is not a normal price (e.g. it could be a run out special). It also may not be appropriate if the feature is new, raising the possibility that household's perception of the utility derived from the feature may not have stabilised or the manufacturer is trying to extract a price premium for the new feature.

9.13 If there are no overlapping prices, or those prices are not normal, then quality adjustment becomes more difficult. It might be possible to use the last available price of the replaced item or to use estimates of differences in manufacturing costs. Again, using manufacturing costs will only be appropriate if costs broadly correlate with consumer utility.

9.14 There are other circumstances where the use of price differentials as indicators of quality differentials may not be appropriate. Examples include items that are heavily subsidised or regulated, such as public education and pharmaceuticals.

9.15 For more complex quality adjustment needs, statistical techniques such as hedonics may be used. The hedonic technique involves the use of a regression equation - the hedonic function - in which prices from an array of different varieties of a product are the dependent variables, and the characteristics of that product are the independent (or explanatory) variables. The estimated parameters from the regression provide implicit prices for each of the price determining characteristics of the good. In simple terms, hedonic modelling divides a good or service into its component characteristics, and uses these characteristics as explanatory variables for the price.(footnote 1)

9.16 Although this form of modelling is intuitively appealing, large amounts of data and many calculations are required, and this is expensive. An additional problem is that hedonic techniques are not readily able to deal with quality changes that are not easily quantifiable, such as the handling characteristics of a car, the quality of medical care, or whether a variety of clothing is in or out of fashion.

9.17 For some types of quality change, it is doubtful if any accurate measure of the change can be calculated. For example, consider changes in motor vehicles in such characteristics as road holding, safety, cabin space and type of wheels. In the case of services, consider changes in medical operating procedures (e.g. keyhole surgery) that involve less pain and a speedier recovery, or educational services making a greater use of computers. In these cases it may be necessary to make subjective adjustments or no quality adjustments at all.

9.18 One important area of quality change is that arising from governmental regulations. It is ABS practice that, unless these changes clearly affect the level of household utility, they are not treated as quality changes. An example of this practice is that any higher price for motor vehicles occasioned by mandatory pollution requirements is regarded as a price increase, not a quality improvement.

9.19 An important issue is whether a change to an item should be regarded as a quality change to an existing item or the creation of a new item. The simpler approach is to assume that the item is new, and to splice it into an existing price sample. However, a splice implicitly assumes that the difference in quality is equivalent to the price difference. Clearly, if it is assessed that a price differential is not a reliable indicator of quality or household utility differentials, then some other appropriate quality adjustment should be made.


NEW GOODS AND SERVICES

9.20 From time to time, major changes in existing products and services take place, or new products and services become available on the retail market and begin to account for a significant share of household expenditure. Some examples in recent years are MP3 players and electronic games. In these cases, careful consideration is given to whether these new goods or services should be priced for the CPI.

9.21 If a new product or service is deemed to be a completely different category of product (i.e a new expenditure class) from any of the goods and services already included in the CPI, its inclusion would be considered only during one of the periodic reviews of the index. The inclusion of television sets in the 1960s is a good example of this. However, where a new product or service falls within the definition of an existing expenditure class (e.g. the introduction of colour television sets, or mobile telephones), the issue is when and how to start measuring its price movements for the CPI. Normally, the decision is made after considering the following factors.

• The product's share of the market. This has to be substantial before there is any point in introducing a new item;
• Whether the product is firmly established, and expected to become a permanently significant item of expenditure, or is merely enjoying high sales temporarily because of novelty value; and
• Whether a normal price structure has been established, that is a price structure that is not unduly influenced by factors such as prestige, novelty value, or scarcity of the product.

9.22 In general, a conservative approach is taken when dealing with the introduction of new goods and services into the CPI. They are introduced into existing expenditure classes only after it is deemed that they have become widely available to the buying public, have become a permanent part of household expenditure, and their price structures are free from premiums attributable to novelty value or scarcity. All introductions of new items are handled by splicing the new item into the index so that its introduction does not affect the level of the index.

1 The ABS has developed hedonic price indexes for computers. Details are provided in Information Paper: The Introduction of Hedonic Price Indexes for Personal Computers (cat. no. 6458.0).

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