Economists use hedonic adjustment to account for changing quality of CPI items : The Indicator from Planet Money We all need a little hedonism in our lives sometimes. A spa day, a good meal ... and modeling to account for quality change? Today, how economists model pleasure – and what it means for inflation data.

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Hedonic adjustment: how to measure pleasure

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SYLVIE DOUGLIS, BYLINE: NPR.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

ADRIAN MA, HOST:

One of the most talked about indicators in America today comes from the consumer price index - you know, that metaphorical basket of goods and services economists use to track inflation? Well, today the CPI shows inflation increased 7.7% in the past year. And that is actually good news because while stuff is getting more expensive, it is happening a little more slowly than it was a month ago.

WAILIN WONG, HOST:

But lately, we've been wondering - if the CPI shows changes in the price of stuff we buy, how does it account for the fact that the stuff we buy also changes over time? For example, how can you possibly compare the price of, like, a brick phone from the '90s with the latest smartphone?

MA: It turns out economists have a trick for this, and it's called hedonic adjustment. So hedonic comes from the Greek word for pleasure. So today on the show...

(SOUNDBITE OF THUNDER CRASHING)

NICKY OUELLET, BYLINE: (As Hedone) Did someone say pleasure?

MA: Oh, who are you?

OUELLET: (As Hedone) I'm Hedone, daughter of Eros and Psyche.

WONG: O-M-G, I think I learned about you in school.

OUELLET: (As Hedone) Oh, then you know that I am the goddess of pleasure, enjoyment, delight (laughter).

MA: Oh, wow. Are you going to help us, like, explain how economists account for pleasure in inflation?

OUELLET: (As Hedone) No, that sounds boring. How about instead we just relax, maybe have a drink? You two seem really stressed.

MA: Well, I mean, maybe a little bit.

WONG: OK. OK. You know, I think a drink sounds good. And I think I left some ingredients for a Negroni in the breakroom. Could you go grab those?

OUELLET: (As Hedone) Sbagliato? Splendid idea. I'll be right back.

WONG: All right. I think I bought us a few minutes. Now, where were we?

MA: I don't know.

WONG: Focus. Focus, Adrian. This is THE INDICATOR FROM PLANET MONEY. I'm Wailin Wong, your co-host.

MA: And I'm Adrian Ma.

WONG: Correct. Today on the show, we look at the technique inflation researchers use to measure pleasure.

OUELLET: (As Hedone, laughter).

(SOUNDBITE OF MUSIC)

MA: Think of a television, right? Today, a typical TV is a flat-screen, ultra-high-def picture, built-in streaming kind of thing with a whole lot more bells and whistles. And compare that to a TV, say, in the early 2000s - right? - when TVs had these curved screens that look like fishbowls that were bulky and box-shaped.

STEVE REED: I could go back way farther than that. I could go back to where our TV was an enormous piece of furniture, a huge console that took up about a fourth of the room. And of course, we got three channels.

WONG: Steve Reed is an economist at the Bureau of Labor Statistics. Since his childhood, TVs are one of these products that just seem to get better and better every year. And while that's good for consumers, it actually makes it more difficult to assess how the price of TVs has changed over time.

MA: Right. I mean, think about it - comparing a TV from two decades ago to one today is not apples to apples. It's more like comparing apple pie to applesauce. And this is not just a problem with TVs, of course - computers, phones, home appliances, even clothing.

REED: Let's say I'm going to go back to 1980 because that's when I was a kid. Compared to now, people are buying a completely different set of things, right? In fact, many of the things that we buy now didn't even exist in 1980. But we've had to, over the course of time, measure price change through that whole time period.

MA: So what do economists do when products become really innovative or obsolete? One approach - they could take those items out of the consumer price index.

WONG: Throw them out of the basket.

MA: Right. Goodbye, TV. Goodbye, cell phone. But the problem is that the CPI basket is supposed to represent what Americans are buying. And if you're constantly removing items because something newer or better comes along, pretty soon all you're going to have is, like, white bread and pork chops.

WONG: So what do BLS economists do instead? They periodically adjust their basket to account for improvements in quality. One way the BLS does this is through our phrase of the day - hedonic adjustment.

MA: And the idea behind hedonic adjustment is this - when products get better, consumers get more utility, aka pleasure. And economists being economists actually have an equation for this. Do you see that?

WONG: Yes. So you're sharing with me now this long equation, the hedonic regression model. Got to say, Adrian, it's all Greek to me.

MA: (Laughter).

WONG: A lot of variables here.

MA: But luckily, we have somebody to translate it for us, another BLS economist named Ryan Watkins (ph).

RYAN WATKINS: I'm what we consider a commodity analyst, so I specialize in mostly apparel items.

WONG: Whether we're talking about TVs or clothing, the process of quantifying utility or pleasure usually starts by building a model - not like Bella Hadid but a statistical model. And building that model, Ryan uses a fancy math called regression modeling to figure out which features really make a difference in the price.

WATKINS: Say, we're talking about women's dresses, OK? And we can start out with a whole bunch of characteristics such as the length of a dress, the brand, the fabric - whether or not it's cotton, polyester. So, for example, if we're building a dress model, our model could tell us that the fabric of the dress is statistically significant to the price. Whereas our model might say, you know what? It doesn't matter if the dress is blue or red.

MA: And I mean, is there, like, a category for just, like, looks good?

WATKINS: That would be hard to quantify.

MA: That's really too bad because I could use an equation to, like, tell me whether my shirt matches my pants.

WONG: (Laughter) You need an equation for that?

MA: I do, yeah.

WONG: By breaking down a product's price into these various attributes, economists have a way to track product categories across time, even as certain products disappear or get better. They can tweak their calculations to make sure they're comparing apples to apples.

MA: So let's say, for example, super itchy, polyester dresses are the thing. They're everywhere. But then next season, they go out of fashion. What's in now is super comfy, space age dress fabric, which is all the rage. But it is more expensive, too, and that means the average price of a dress has gone up, say, 20%. So what hedonic modeling allows economists like Ryan to do is figure out just how much of that price increase is due to market conditions and how much of that change is the product itself, right? So maybe after running the numbers, that 20% price increase, it's actually more like 10%.

WONG: Now, two things worth noting about this - Steve says hedonic adjustment does not have a huge impact on the consumer price index overall. That's because it doesn't work for a lot products.

REED: There have to be visible, observable features that we can sort of identify and record. You know, there might be frozen pizzas that we're pricing, and the characteristics of that pizza might change but not in a way that we can sort of observe and put into a model.

WONG: The second thing to consider about hedonic adjustment is that it could obscure the impact of inflation on some people. Take internet service. It seems like today the cheapest plan you can buy is a hundred megabits per second. But for a lot of people, they might only want or need a 10-megabit plan. But if a hundred is the only option, they end up paying more for something they don't really need.

REED: Many consumers might prefer sort of the lower quality, lower price option, and they may not have that. And so when quality goes up and price goes up, you know, like, there's an argument that you're not fully capturing the impact of price change on lower income consumers. And, you know, we're actually doing research now focusing on some of those issues affecting lower income consumers and looking at price change for them.

MA: For now, Steve says hedonic adjustment is a pretty good if imperfect solution for comparing old products and new ones. And like economics in general, there is a little art involved in the science.

(SOUNDBITE OF THUNDER CRASHING)

OUELLET: (As Hedone) Yoohoo (ph), I'm back.

MA: Hey. Hey. It's good to see you again.

OUELLET: (As Hedone) Yeah, I thought it would be. You know, Wailin, I couldn't find that Negroni materials or whatever that you talked about. So I just popped on over to Mount Olympus. I picked up some ambrosia.

WONG: Oh, oh, but we're not done yet. We have to do the credits.

OUELLET: (As Hedone) Oh, girl, please. Let me just pour you a little glass.

(SOUNDBITE OF MUSIC)

MA: This episode was produced by Brittany Cronin and engineered by Gilly Moon. Dylan Sloan checked the facts. Viet Le is our senior producer. Nicky Ouellet is our goddess of pleasure. Kate Concannon edits the show, and THE INDICATOR is a production of NPR.

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