CPI Bias

by Russ Roberts on September 7, 2006

in Standard of Living

In this earlier post, I mentioned work by Jerry Hausman and Ephraim Leibtag, and Mark Bils on why the CPI and inflation are overstated and therefore the standard of living of the average American is understated. Here are two relevant quotes from their work that gives you a feel for the magnitudes involved. The first is from the Hausman/Leibtag paper that discusses how the failure to include Wal-Mart Superstores in the measure of food costs in the CPI biases it upward:

Hausman (2003) discusses four sources of bias in the present calculation of the CPI. A "pure price" index based approach of surveying prices as done by the BLS cannot succeed in solving the problems of bias. We discuss economic and econometric approaches to measuring the first order bias effects from outlet substitution bias. We demonstrate the use of scanner data that permits implementation of techniques that allow the problem to be solved. In contrast, the current BLS procedure does not treat correctly outlet substitution bias and acts as if Wal-Mart does not exist. Yet, Wal-Mart offers identical food items at an average price about 15%-25% lower than traditional supermarkets. The BLS "links out" Wal-Mart’s lower prices. We find that a more appropriate approach to the analysis is to let the choice to shop at Wal-Mart be considered as a "new good" to consumers when Wal-Mart enters a geographic market. This approach leads to a continuously updated expenditure weighted average price calculation. We find a significant difference between our approach and the BLS approach. Our estimates are that the BLS CPI-U food at home inflation is too high by about 0.32 to 0.42 percentage points, which leads to an upward bias in the estimated inflation rate of about 15% per year.

The Bils paper looks at what happens when a manufacturer of a consumer durable (cars, televisions, computers and so on) drops one of the models in their product line and replaces it with another. The BLS has been following the price of the old model and now it has disappeared. They replace it with another model that is "similar." But if the new model is improved in quality (as it often is), the price of that new model is not really comparable and the measured prices will overstate inflation. The BLS does try to control for this effect, but Bils tries to measure how effective those controls are. He finds that in many cases, they are inadequate. Here’s an excerpt from Bils’s intro:

Much of economic growth occurs through growth in quality as new models of consumer goods replace older, sometimes inferior, models.  Moulton and Moses (1997) estimate that Bureau of Labor Statistics (BLS) methods allowed for perhaps as much as 1 percent average quality growth in goods in 1995.  It is often argued, however, that the Bureau of Labor Statistics (BLS) methods miss much of the growth in goods’ quality.  (Hausman, 2003, and Pakes, 2003, are two recent examples.  Shapiro and Wilcox, 1996, review much of the previous evidence.)  The Boskin Commission Report (1996) suggests that the BLS overstates inflation by perhaps one percent per year.  Unmeasured growth in quality of goods is put forth, based on examining a fairly limited set of goods, as the most important component contributing an overstatement of inflation of 0.6 percent per year.   The need to measure quality growth arises from changes in the products available to consumers. To calculate the CPI the BLS tracks the price of a specific product at a specific outlet.  The products followed change for two principle reasons.  At scheduled rotations, roughly every four years, the BLS draws a new sample of stores and products within a geographic area to better reflect current spending.  In addition, a store may stop selling the particular product being priced.  The BLS agent then substitutes another model of that brand or a similar product.  These (forced) substitutions occur on average about every three years for all non-housing CPI items.  They occur much more frequently, nearly once per year, for consumer durables.

And from his conclusion:

For vehicles my results suggest that quality growth has been understated by at least three percent per year.  My results suggest growth for consumer electronics has also been substantially faster than historically measured, by two percent or more per year. For the balance of durables, if price inflation is reasonably well captured by the rate of inflation for matched products, then annual quality growth is about one and one-half percent faster than suggested by methods underlying BLS measurement of the CPI.  Putting it all together, this suggests quality growth that is two-and-half to three percent faster per year than has been measured for these durables, with a resulting growth rate of at least five percent per year even with computers excluded.  My results suggest much faster quality growth for durables than the Boskin Commission Report, which stated BLS methods understated quality growth for durables by about one percent.  This derives from two main differences: (1) The Boskin Report assumed no quality bias for a number of durables; (2) The Report assumed no quality growth for vehicles except from greater durability.

These are not trivial differences. If Hausman and Leibtag, and Bils are right, the CPI we use to deflate wages and earnings is seriously overstated.

Again, I challenge the pessimists, the doom-and-gloomers who accept the wage data as indicating that for 30 years, the average American has made no progress. Either our economic system is broken or are data collection system is broken. There is dramatic evidence that the data collection system is unable to cope with the speed of change in the US economy. Why do you believe instead that it is the economic system that is broken? Where is your evidence?

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{ 18 comments }

Don September 7, 2006 at 10:19 am

Great stuff. What about things like "owner's equivalent rent" which arguably leads to understatement of CPI, at least recently. Has there been any work done to look at this side of the ledger and net out the under and over-statement effects?

Bruce Hall September 7, 2006 at 10:29 am

You may be correct about the CPI being overstated based on the quality or substitution alternatives not being considered.

Ironically, the one area with the greatest inflation for which there is no evidence of quality improvement or available substitution is a college education.

There are about 17 million college students and the rate of cost increase for tuition has been 1.5 to 2.0 times the general rate of inflation for 1/2 a century. If the general rate of inflation is overstated, then the cost of a college education has increase even more rapidly compared to other costs. http://www.finaid.org/savings/tuition-inflation.phtml

While you might argue (self-servingly) that the quality of knowledge being taught is better, the truth is that for a comparable product providing comparable value (or maybe less because the degrees are less unique among the general population) for the customer (student), the cost has risen dramatically.

It's great to stand in judgment without being judged, isn't it?

Russ Roberts September 7, 2006 at 10:48 am

Bruce,

Your point about tuition increases relative to the general price level is absolutely correct. You are also correct that there has been little in the way of quality improvements in education. Don't understand what your point is about "being judged." Education has become more expensive over time for two reasons. The first is that the increase in demand for teachers has pushed up salaries. Unlike manufacturing, people have been unsuccessful in finding machines that can substitute for people in education (although on-line education is still in its infancy and appears to be growing in importance. But the second reason has to do with the "quality" issue after a fashion. True, the quality of education hasn't changed much over time and may even have declined. But for better or worse, teenagers come to college for more than education. The demand for the "life-style" of college has driven up costs as colleges build plusher dorms, serve better food and so on. So the full cost of college (tuition plus room and board) is being driven by more than education.

Mike September 7, 2006 at 10:48 am

Bruce,

While the sticker prices have been rising dramatically at colleges for decades, the actual average net price of attending most colleges has not taken up much larger shares of income in two decades. What matters is the net price paid by students. You can check out the College Board's Trends in College Pricing and Trends in Student Aid reports to confirm. Even so, the places where actual per student net prices have increased dramatically enroll a miniscule proportion of our nation's college students.

Don Lloyd September 7, 2006 at 10:57 am

Russell,

Your attempt to intermix standard of living and cost of living leads only to confusion.

With the NFL regular season starting tonight, try answering this question.

Your hometown team went 0-16 last year and it cost $100 for a particular ticket.

This year's team is going to win the Superbowl and go undefeated. It now costs $200 for an equivalent ticket.

Has the cost of living gone up?

Answer – yes.

Has the standard of living gone up?

Answer – probably.

The quality of play has greatly increased, but you can no longer buy a $100 ticket to last year's losers even if you want to.

Regards, Don

Bret September 7, 2006 at 11:46 am

Russell Roberts wrote: "Either our economic system is broken or are data collection system is broken."

Or neither.

I think that it's quite unrealistic to expect that the data collection system could produce statistics that have any absolute objective meaning. The system is way too complex for that. The best that can possibly be achieved is that during consecutive, short time periods, the data can produce statistics that can be compared, though with fairly low confidence.

In other words, perhaps we can compare this year's per capita GDP growth with last year's in a relative sort of sense (we have some confidence that we're growing faster or slower given the measurement methodology and the inherent limitations), but not in an absolute sense.

The problem with all of the quality modifications to CPI is that they're somewhat subjective. Bils' points are good, and his proposed methodologies seem to have merit at first glance, but they're not flawless either.

It's impossible to come up with a perfectly objective number. I think that that's the important message here. Not that the system is broken, which implies that it can be fixed, which it can't. Only our expectations of the system can be fixed.

Aaron Krowne September 7, 2006 at 1:27 pm

So inflation is still over-reported, after a decade of downward-revisions in the methodology? Really, tell me another one.

An obvious problem I see with this "Wal-Mart effect" claim is that if Wal-Marts /were/ included in the CPI, then a reporting adjustment would only happen once. You'd get an anomolously low CPI, then it'd return to the previous levels next reporting interval.

If the effect being referred to is the ongoing opening of new Wal-Mart and other big box discounter stores, then you still have a temporary effect–albeit one that is longer lived. That is, when the big boxes reach a point of saturation, the "adjustment phase" to the CPI will be over, and it will resume its hated rate of growth.

But this is all niggling. In reality, the most impactful elements of the rising CPI are in services–especially health care–and scarce commodities (energy and materials).

Further, I'm with Don Lloyd: mixing quality (standards of living) growth with cost of living growth is totally illegitimate. To see this, imagine if the two effects were separated out: there'd be very little debatable about surveying price levels for a pure cost-of-living metric, but there'd be almost no end to the arguments on how to numerically value rising quality and standards of living.

So let's be frank. You already believe there's no inflation in the system, basic material scarcity and money supply growth be damned. So why not just set the CPI equal to 1 or 2% and be done with it?

Cyberike September 7, 2006 at 1:58 pm

From my perspective, inflation is vastly under-reported. I think the Wal-Mart effect is inconsequential, and not just because I don't shop there. I simply dont spend that much on food and other goods.

Where does my money go? How much does it cost for the necessary expenses of life and how do the costs compare over 30 years?

Certainly I live in a better house than I did in 1975, but my costs have gone up by a factor of 5 (500%). My electric bill is outrageous.

But I want to make a new arguement: you have to include those things that are now necessary that did not exist 30 years ago.

I had no cable bill, no internet bill, no cell phone's. Those items right there add about $200 to my monthly expenses. I see no one taking these types of items into account, yet they are certainly factors in the cost of living. Have they added to my quality of life? Yes. Do we consider them necessities? Also yes.

Lets see an analysis with these factors included.

Bret September 7, 2006 at 2:14 pm

My mother has no cable bill, no internet bill, and no cell phone. She's pretty well off and lives just fine without them. I don't think you can really call any of those things a necessity. Some people can't live without heroin – that doesn't make it a necessity.

TGGP September 7, 2006 at 2:38 pm

How can something be a necessity if people lived for millions of years without it?

dj superflat September 7, 2006 at 2:54 pm

your cable comment proves the point: people could so cheaply have a 1970s standard, it's silly. no cable, no cell, no voicemail, no starbucks, no eating out, no wholefoods/organicwhatever, no movie rentals, no $100 shoes, no internet, no bottled water, and on and on (and these are all things significant chunks of the "poor" people in the US take for granted). you could live like the grandma for next to nothing. you'd also get a way better car for far less money — a late 90s used honda is so much better than even a somewhat pricy sedan from the 70s it's scary, a way better bike, a nicer TV for less money, a calculator for a few dollars instead of tens of dollars, etc. and this all ingnores the easy credit available today that lets all sorts of people buy things that someone in their situation in the 70s never could (and, yes, they get in debt, go bankrupt, etc.).

Kevin September 8, 2006 at 12:50 am

*** I see no one taking these types of items into account, ***

I don't think you understand what inflation is. What you're experiencing is not inflation. You're experiencing that same unquenchable desire for ever-more luxuries that cause lottery winners to spend all their money.

Just as people who make 10 times as much money as I make somehow find a way to spend it all and think they have trouble making ends meet, people today are far far wealthier than people were in the 1970s, yet still find new and innovative ways to spend their money.

As has been written before on this website, people always want MORE. That's human nature; it's not inflation.

Spectator September 8, 2006 at 1:14 am

It's apalling that someone can usurp the Hayek name and be so ignorant about inflation.

So if I pay twice as much for gas, but have a nicer drive for other reasons, it's not inflation?

Human progress and inflation are independent variables. Don't try to hide one with the other.

Aaron Krowne September 8, 2006 at 1:34 am

> It's apalling that someone can usurp the Hayek name and be so ignorant about inflation.

Bravo, Spectator.

I'm sure Hayek would not have approved of the way the term "inflation" is being used around here.

Cyberike's cable counter-example drives the point home: the "bar" for the "median stuff required by the median person to live a median life" is continuously rising. This is due to the natural workings of the economy through time, and is completely orthogonal to the problem of measuring precisely *what* the cost is at that median bar.

As per Cyberike's cable TV example, the BLS inherently lags behind the curve in including new "necessities". I would venture to guess that the numerical counter-adjustment for this effect is not insignificant.

But I'll let the CPI-manglers have this one, if they simply give up geometric weighting and hedonic adjustments.

john g September 8, 2006 at 9:04 am

Inflation is a monetary thing. I prefer to watch gold than sift through the CPI. With gold still over $600 an ounce, and if it stays there, inflation is coming. It will happen first in commodities like oil (doh!) and metals, then things made with commodities like automobiles in a few years and lastly houses in about 10 years.

I have heard something recently that I have not heard in about 20 years. People talking again about whether their pay raises are matching the cost of living.

WeldonM September 8, 2006 at 10:28 am

"I prefer to watch gold than sift through the CPI. With gold still over $600 an ounce, and if it stays there, inflation is coming…"

____________

The gold-price is also a very unreliable measure of $Dollar inflation.

Gold was over $600 in 1980 … and less than $300 in year 2000.

By official inflation rates from those two dates — then Gold should now be over $1600 from the 1980 price … OR .. now about $350 from the year 2000 date.

???

Can U.S. "inflation" rate be measured at all (?) … or even reasonably estimated ?

Can anybody confidently state the current U.S. infaltion rate ??

lurker September 6, 2007 at 1:27 pm

Bruce –

Your education inflation argument only makes sense if you treat education as an expense item. But education is not a flat-screen TV or a Buick. Education is an investment. And the expected return on that investment (income over a lifetime) continues to explode relative to the alternatives.

The benefit is clearly growing faster than the "cost." College education is a better deal today than it was 30 years ago, no matter how you measure quality. Period.

Not that this is an uncommon mis-allocation.
It's one of the reasons for the so-called "low savings rate" in this country. Treating (rising) education cost as expense rather than investment means every year Americans "save" less, but they're better off for it. Go figure.

Flash Gordon September 7, 2007 at 1:56 pm

The "data collection system" is a product of the people who designed it and who collect the data. There is seldom an error in data that is not blamed on a faulty system, but often the data errors just so happen to support the results the data collectors were looking for in the first place.

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