Reference no: EM13733753

The U.S. economy is one of the most dynamic in the world, marked by rapid technological change. The Bureau of Labor Statistics (BLS), the government agency that calculates the CPI each month, employs dozens of economists to analyze the impact of any quality changes to products in the CPI market basket. Each month 400 data collectors visit stores to record about 85,000 prices for 211 item categorie in the CPI basket. About a week before the CPI is released, the BLS office is locked down with bright red "restricted area" signs on all the doors. A total of 90 people, including product specialists and the other economists working on the CPI, compute the basic indexes in each category. Results are released at 8:30 a.m., Eastern Time, about two weeks after the end of the month in question. This release is a big deal.

Most price adjustments are straightforward. For example, if a candy bar shrinks 10 percent but still sells for the same price, the CPI shows this as a 10 percent price increase. But sometimes a product changed in a more complicated way. Economists at BLS specialize in particular products, such as televisions, automobiles, kitchen appliances, and so on. One of their greatest challenges is to identify substitutes for products that are no longer available on the market. For example, data collectors find the model of TV they priced the previous month is missing about one fifth of the time. When a particular product is missing, a four-page checklist of features such as screen size and the type of remote control guides the data collector to the nearest comparable model. That price is reported and the product specialist in Washington must then decide whether it's an acceptable substitute.

For example, the TV specialist decided that the newer version of the 27-inch model had some important improvements, including a flat screen. A complex computer model estimated that the improvements alone would be valued by consumers as worth $135 more. After factoring improvements into the price of the $330 set, the analyst determined that the price of the TV had actually declined 29 percent [= 135/(330 + 135)]. In another example, the price of a 57-inch TV dropped from $2,239 to $1,910, for an apparent decline of 15 percent. But upon closer inspection, the analyst found that the new model lacked an HDTV tuner that had been included in the model it replaced. This tuner would be valued by consumers at $514. So, instead of declining 15 percent, the price of the 57-inch TV actually rose 11 percent [= 1,910/(2,239-514)].

The TV analyst is applying the hedonic method, which breaks down the item under consideration into its characteristics, and then estimates the value of each characteristic. This is a way of capturing the impact of a change in product quality on any price change. Otherwise, price changes would not reflect the fact that consumers are getting more or less for their money as product features change over time.

Question: What is the hedonic method and why is it sometimes used to track changes in the Consumer Price Index?