Lower bound problems of hedonic indices

Prices are a fundamental feature of modern economies, yet measuring a true price change is exceedingly difficult due to the constantly changing quality of goods and services. I have previously discussed the use of hedonic price indices, where adjustments are made for quality changes using regression techniques, and the potential pitfalls when interpreting the results of this method. I apologise for raising this issue again, but I hope to clarify my message with an example.

While a hedonic index is a useful tool, and when part of a package of price indices can clarify our understanding of price and quality movements, many unresolved issues persist. One issue that attracts little attention is how to interpret and apply results from hedonic price index calculations.

Today I want to further elaborate upon, and demonstrate using the table below, what I call the lower bound problem of hedonic price indices. Quality improvement does not imply that prices faced by consumers have dropped, especially if lower quality goods are no longer available. Buyers of cheaper products will not see the price declines measured by a hedonic index, and may even see price increases.

The above table has been constructed to show how different methods for determining price changes can produce significantly different results. This hypothetical market could be computers, cars, or any other market where quality changes noticeably over time.

The animal names are the models. For car markets, it could be Corolla, Landcruiser and so on, or for computers, Dell Latitude, Apple MacBook or any other model. The reason to include models is that one method for determining price changes is called the model-matching technique. Because models typically have fewer quality changes than the market as a whole, and that they typically represent a segment of the market (budget or premium), compiling prices over time for the same model can give a reasonable measure of price changes for similar quality products. In the table above two models are highlighted, Kangaroo and Echidna, to show how their prices have changed over the period. If we take the average price change of models we can match over the period (the model matching technique), we get a price change in this market of -42% over the eight-year period.

The number beside each model is a measure of quality. I have used a single number in this situation, but typically there would be a number of associated quality measures. You will note that the quality of each model improves over time, thus if we use a hedonic (quality controlled) method for measuring price change, it will show a more substantial price decline. If we were to buy a ‘quality level 9’ product in 2001 it would be $3,000, while in 2009 it would be $1,000 – a 67% decline in price.

Using a median price index, where quality is not considered, the data in this table shows a median price increase of 14% over the period (assuming an equal volume of sales in each price category). In this scenario, this measure more accurately shows the price movement of the market as a whole. If you wanted to stay at the same level in the market, this is the price change you would experience.

Finally, and this is the main pitfall when utilising quality-adjusted prices measures to make policy decisions, the price change for the lower bound market entrant has increased 33%. The cheapest computer/car/shoe/phone/appliance, or whatever good this happens to be, has gone up in price significantly while the quality-adjusted measures show large declines.

Measures such as the CPI (a price index) and the Analytical Cost of Living Indexes do consider quality change, yet we apply these measures as a way to adjust welfare payments, even though most welfare recipients will be lower bound market entrants for much of their consumption bundle.

In an ideal world, a selection of price indexes using different methods would be produced for each major consumption category to show paint a clear picture of the situation being faced by different members of society. Not only would we measure ‘pure price change’, but also changes to the cost of living which can more easily guide policymaking.

A Rum Thing

Guest post by Stephen Hogg

This Business Spectator article gave me pause for thought. It is discusses how ASIC recently made a ham-fisted attempt at reigning in rogues in the market making a buck off spreading a rumour and then profiting from inevitable price movements. It’s called rumourtrage, and is the practice of spreading false or misleading information in respect of securities in order to take advantage of artificial changes in market prices.

Now don’t get me wrong, it’s a cunning idea. I know a lot of people who wish they had thought of it some years ago. But I became stuck on one point made by ASIC. At the end of the article it is made plain that when ASIC was figuring out how to put a stop to all this, that:

"The principles were developed noting concerns that confidence in the integrity of Australia’s markets could be undermined if investors believe rumours are actively spread in the market to distort proper price discovery"

I think is a flawed statement.

Barefoot running: The transition and Vibram Five Fingers

Economic instinct initially held back my enthusiasm for Vibram Five Finger (VFF) shoes.  At first glance getting less shoe for your money is bizarre.  At next glance it feels like a step backwards - expensive well-cushioned running shoes, the result of countless hours or research and design, should be the pinnacle of human endeavour toward running excellence.  There are so many people running in this world, both amateur and professional, that you just expect the current technology to be supreme. 

But there are a few reasons I became convinced that making the transition away from traditional running shoes (and shoes in general) to VFFs or barefoot was not a step backwards, but a simplifying step forwards.

- I generally prefer to be barefoot where possible
- The book Born to Run by Christopher McDougall was very persuasive
- Harvard researchers have been analysing the difference in running techniques between barefoot and shod and now running with shoes just looks wrong
- I saw a guy wearing VFFs at an adventure race (about 4hours running, kayaking and mountain biking) and thought he must have got the wrong information about how much time is spent in the water and worn his scuba shoes. 

I also tried running barefoot in the park a few times a week for a month before buying VFFs (the KSO model).  Apart from getting sore calves for a little while, the toe strike technique felt comfortable.  I considered forgoing VFFs and simply running barefoot.  Nowadays it’s either barefoot or VFFs depending on the distance, my mood, or the weather.

Let me share the experience and comment on the bizarre barefoot running culture that is developing.

Cycling culture through economist eyes

I have been fortunate enough to travel widely in the past decade and sample the breadth of human experience. Today I want to focus specifically on the evolution of cycling culture around the globe.

I have taken note of the popularity of my recent post on the proposed bicycle hire scheme in Brisbane and want to expand some of the points I made about the incentives to (or not to) cycle, and compare the diverse cycling cultures around the world.

The comparison will consider such obvious differences across countries such as speed, cost and safety, but focus on the historical development of cycling culture across countries. I will finish with some ideas about how to cities can embrace cycling as a legitimate mode of transport.

Confusing macroeconomic situation

The Reserve Bank has lifted its stimulatory cash interest ratesetting and showed a willingness to continue to tighten monetary policy if required. At the same time, the Federal government continues to spend into the economy with its Nation Building Economic Stimulus Plan. The RBA started contracting their position when the Government was only half way through its rollout of fiscal stimulus. All data upon which the RBA acted was severely affected by the $25billion spent into the economy as part of the Plan. That’s not forgetting the $17billion still to go in 2010.

Unfortunately we have yet to see what is left of the ‘real economy’ once this artificial situation expires.  But at least the RBA has proved their independence.

The reason monetary policy (changing interest rates) works is because is can bring forward, or delay, consumption. Lower interest rates bring forward consumption, as the reward for saving is lowered and people choose to spend more now rather than save and then spend later time periods. The cost of borrowing is also reduced, and can stimulate debt funded current consumption. Conversely, higher interest rates encourage saving and discourage borrowing.

The Nation Building fiscal stimulus package is bringing forward government spending – the exact opposite of what the RBA is trying to do. The remaining $17billion being spent this year will offset the last 3 interest rate increases – each 0.25% rise increased the interest on Australia’s private debt by $4.8billion/annum; money which would have otherwise been spent on present consumption or investment (of course I have overlooked the impact on savings rates in this calculation).

My gut feeling is that the RBA was far more confident then it should have been, and we may see a repeat of the dramatic change in policy that we saw at the end of 2008 when the cash rate was more than halved in a few short months.  There might be some money to be made in foreign exchange - I expect the AUD to decline between now and the end of 2010.  Another forecast to be tested.

Friday quick links

A new direction for interest rates?

For risk taking behaviours, the rebound effect even has a name – The Peltzman Effect

New Mysterious Cities of Gold cartoons on the way.

Broken window fallacy or just plain old human optimism? Café Hayek is full of gems.

Ever wondered why all news is bad?  A must read on what happens to good news.
...there are huge vested interests trying to prevent good news reaching the public. That is to say, in the ruthless free-market struggle that goes on between pressure groups for media attention and funds, nobody likes to have it said that `their' problem is not urgent and getting worse.

Externalities addressed the Dutch way.
...in the Vondelpark, a delightful reserve in central Amsterdam, it is illegal to let your dog off a leash. But it’s perfectly legal to have sex in the park, so long as it is not in view of a children’s playground. The argument is that the dog may make a mess that imposes costs on the unwary walker, while the couple imposes no costs on other park users.

Steve Irwin's way: Economics of wildlife conservation

At Australia Zoo (I had a lovely time there on the weekend, thanks for asking) there are numerous signs posted to encourage visitors not to buy native animal products – crocodile, emu, and kangaroo meat for example.  I found this very odd, as crocodile and emu are farmed, and most kangaroo species are not endangered – far from it.  So what kind of conservation message was this I wondered?

Steve Irwin expressed his conservation message more clearly on the website:

"Sustainable Use" of native wildlife in so-called modern nations like Australia and the U.S.A. has inadvertently created a multi-million dollar 'bushmeat' industry, where local people kill native wildlife for meat, skins and products. Please don't blame the local people; it's not their fault! They're simply hunting for much needed money. The greatest wildlife perpetrators of today's world are those behind the driving force of "Sustainable Use." 

How are the Tiger Farms in Taiwan and China helping to save Tigers in India, SE Asia or Siberia? They are perpetuating the market in Tiger products, which is the single greatest reason for the endangerment of Tigers.

…If we can destroy the market, we'll destroy the industry. Historically the only reason spotted cats, like Leopards and Cheetahs are still found in the wild, is because of peer pressure. It became 'uncool' and controversial to wear spotted cat fur coats, so the market was destroyed and the industry suffered. Slowly, less and less Leopards and Cheetahs were being shot for their skins, and just as well or they would've been extinct 20 years ago.

The principle behind this message is that if we eliminate demand for wildlife products, we will preserve species.  But there are alternative ways to protect wildlife and biodiversity (a side note: do we really care about an individual species, or do we use iconic mammals as the canary in the coal mine of biodiversity protection?)

In addition to the ‘demand destruction’ technique, economists propose other ways to preserve threatened species – promote domesticated supply (farm threatened species), the Coase solution (give rights to the species to a group who can profit from non-consumptive use of the animals such as eco-tourism and research), and simple land conservation.

Which of these measures work?  Should we try them all, or are they mutually exclusive?

How much is this island worth?

I would appreciate some feedback on a little conundrum I face at work.  The following analogy is close enough for our purpose, and what I want to know is how much the island is worth?

Imagine a large island was discovered in Australian waters in the 1960s.  The government takes ownership of the mostly desert island.  It has little environmental value, with a surprising lack of biodiversity, some small mineral deposits that are uneconomical to extract, and otherwise is of little use. 

The government decides that they may as well put the island to some use, and offer people a licence to inhabit the island, and the rights to the minerals and any vegetation they find.  The licence is offered for free with the condition that the licence holder make use of it within 3 years (by inhabiting the island or making use of its resources in some way).  By 2010 a dozen people have licences and inhabit the island.  The government estimates that they could offer 100 more licences before the islands land is fully ‘developed’.

The government changes its licensing policy and decides that licences will be converted in title of the land in the island - much like it is on the mainland.    It now has 12 blocks of land in private hands, and 100 in government hands.

The government then decides to sell its remaining blocks of land to the market.  At what price could they sell these 100 blocks?

I see two drivers of price:

1. The previously free and seemingly non-scarce licence is replaced with a scarce piece of land, therefore people will be willing to pay something simply out of speculation of future value (because they now don’t have to inhabit the island to keep the block).

2. The price is still worth nothing if people weren’t willing to take the licences for free for 50 years.

How do we estimate the market price, if any, of these blocks of land?

iHate Steve Jobs or Why I Won’t Buy Anything Made by Apple (Yet)

Guest post by Ben today

At the moment it seems that the ascendance of Steve Jobs and the Apple Empire knows no limit. With the media player and smart-phone markets sewn up and their eyes firmly set on conquering the tablet PC market with the omnipresent iPad, it seems that Apple can do no wrong.

But not for me; I can see the Apple vision for the future and it’s a safe, bland, white-chrome corporate hell. Why do I say this? Well maybe it might have something to do with:

• Apple’s restrictive licensing conditions for the sale and development of apps which basically amounts to censorship and discourages innovation;
• Their refusal to allow 3rd parties to sell apps; iTunes is it – monopolistic price gouging anyone?
• Draconian digital rights management – installing unlicensed apps on you iProduct voids the warranty as does ‘jail-breaking’ them;
• Stupid ongoing court antics with Adobe meaning that iProducts aren’t compatible with Flash;
• Rechargeable batteries which can’t be replaced;
• And the thing that irritates me the most: requiring the use of propriety peripherals e.g. iPod shuffles are designed so that you can only use Apple headphones; USB devices or HDMI monitors can’t be plugged into an iPad - you need to purchase a Apple ‘adapter’ first etc.

But these are secondary to my main issue with Apple, which is their pricing policy.

Housing crash makes us winners and the bubble checklist

It’s no secret I am forecasting price declines (or prolonged stagnation) in the Australian residential property market. The intricacies of this topic have led many to the conclusion that the government won’t let that happen - there are simple too many people going to lose in the short run, even if we may all benefit in the long run. While I agree that the government may not let this happen (although foreign ownership rules are being tightened up again), and may produce an arsenal of economic weapons we haven’t even though of yet, I disagree that there are more losers than winners from a significant housing price correction.

The mainstream ‘more losers than winners’ message is aptly summarised in this article:

The only people who would rejoice in a house price slump, it seems, are the young and aspirational. As Willem Buiter put it in his 2008 paper for the National Bureau of Economic Research, 'Housing Wealth Isn't Wealth', “…the young and all those planning to trade up in the housing market are made better off by a decline in house prices. The old and all those planning to trade down in the housing market will be worse off.”

This view is wrong.