Tuesday, August 16, 2005

The Insult of Hedonic Adjustments

On the subject of "Hedonic adjustments", the Austrian economists treatment usually revolves around the inherent fraud that these downward adjustments reflect upon the government's index of price-inflation. Not that I've read every single dissertation of course, but of late I have come across a few Mises and LewRockwell articles or blog posts, and especially by Messrs. Karlsson and Mueller.

One of the first points usually raised is that the Bureau of Labor Statistics engages in disingenuous behavior when conveniently choosing to emphasize the lower core index and leaving out the more volatile goods, or their inclusion when it will be more favorable to do so.

More importantly, the method of how the index is compiled is discussed. Mueller's article titled "The Illusion of Hedonics" clearly demonstrates that the calculation required for hedonic adjustments is impossible, and thus any attempt is really no better than anyone's guess. Karlsson writes "Because the state for this reason has a self-interest in underestimating inflation, it is clear that one should be sceptical [sic] towards the official numbers" and by example decries the housing price being calculated upon an "home owners equivalent rent", which therefore results that the index does not represent the higher cost of home ownership.

However, it seems to me that no one in particular takes issue with the implementation of hedonics being used to offset price inflation; it is but in the sloppy, inaccurate and especially political application of the adjustments in which they denounce it. So to borrow a cliche, if the Angel Gabriel came down and gave us the exact and objective index numbers, I'd suspect that these economists would be warmer to its use.

For example look at what Mueller states-
"However, how many technical improvements are being offered every day and there is no market for them?"
and later
"The consumer himself will judge to his best knowledge and preferences whether he likes the product or not. With respect to its price, he will decide to buy or to abstain."

On the corresponding Mises blog, Karlsson states-
"Regarding hedonics, it is not in principle wrong to take that into account as a better product could be seen as equivalent to more products."

Of course they are certainly correct to point out that the BLS most likely overstates the benefit that the consumer derives from the improvements, and thus the price inflation is potentially understated.

It is on this very point I wish to lay yet another criticism of the hedonic adjustment, based not from the consumers' point of view, but rather from that of the entrepreneur. The popularly maligned entrepreneur is the victim of unrealized theft when the BLS applies hedonic adjustments to the money prices of his improved consumer goods.

I do not claim to fully understand the methodology of the BLS prestidigitators, but I hope my forthcoming fabricated example will address my concern adequately.

Suppose the average 23" TV sells for $100 in 2003. Now we find that in 2004, the average 23" TV now includes a digital comb filter, and other improvements not found in the average 2003 model, but yet now is priced at $110. The BLS will now say that improvements X, Y and Z of the average TV in 2004 are worth some figure above the $100 in 2003, and therefore will wash the 10% price increase with the hedonic adjustment, and claim that the price inflation was significantly lower, neutral or even negative!

What I see happening here is that some entrepreneur went forward on spending his time, money, energy and ingenuity in order to offer the consumer more competitive bang for his TV buck. This probably involved the coordination of the many factors encountered in such areas as the R&D phase, market research and preparing marketing materials, the manufacturing process, labor relations, vendor negotiations, consumer advertising, etc.

Due to efficiencies the entrepreneur discovers and implements in these processes, his cost for producing a 2003-level model might be significantly lower than in the previous year, yet because one of the lower-order goods, suppose the plastic housing, now doubled in price due to general price inflation, he might only be able to deliver the final good at $95 MSRP versus the $90 which would have been possible sans price inflation.

Likewise, the 2004 model with many improvements, the entrepreneur was planning on delivering it for $100 MSRP, yet also due to price inflation, the market price is established at $110 for the average 2004 TV set.

In both cases, when offering either the old or newer technologies, the entrepreneur worked to bring better value to consumers. In both cases, price inflation ate away the consumers' potential savings, which would have appeared as lower market prices for either TV set. Savings that the entrepreneur would have brought them with his toils.

But all this is virtually transparent to the consumer. All they see is general price increases in the new items, and slight decreases in the older items. They don't realize that the newer technology could have been selling for a lower market price than the old technology used to.

This is why I find it fraudulent when the BLS compiles an index which utilizes the black-magic of hedonics to make price inflation less of a bitter pill. The BLS's adjustments does not recognize that entrepreneurs did the most to counter the Fed's counterfeiting efforts, and instead they attribute the increases to the improvements through questionable measures and call it a day.

The BLS thus hides the price inflation with the efforts of the entrepreneur. I like to think of this as theft, but in the least it is definitely an insult.

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