Quality Adjustment in the Producer Price Index (PPI)


1 Quality Adjustment in the Producer Price Index Overview fixed-input The Producer Price Index (PPI output price index. It ) is a constant quality measures by following the prices of a representative sample of economy monthly price change in the items each month. A detailed each item an d the way it is sold is considered its description of p measures only 'pure' price change based on mark et factors, it rice basis. To ensu re the PPI items must ex clude any change in p e to a change in the price basis rice of the sampled that is du the way the item is sold. BLS emp loys item or changes in such as physical changes to the in the price basis. In normal monthly quality adjustment procedures to adjust for changes p roduction of the PPI, the staff of Industry Analysts reviews every item that has any change to iption or terms of transaction to determine if the price basis has changed and what action its descr be taken. should Basis Describing the Price The PPI samples and collects its by industry. Before a sample of items is collected, a BLS items I e economics of ndustry Analyst studies the industry, including the range of production and th identify changes in the price basis, collection mater ials y. Because it is important to the industr are desig captures every price variable associated with an item. determining ned to en sure the PPI tem information i s collected on a checklist describin g the physical During initial collection, i characteristics of a product or an exact description of the service provided and any terms of transaction, such as the type of buyer, the quantity sold, and any contract terms. Monitoring the Price Basis respond ents provide prices for their items. They are Each mo nth subsequent to initial collection, also asked to co If terms nfirm all of the details of the product specification and of transaction. changed, an Industry Analyst contacts the respondent to discuss the change and any o f th ese have Analyst r eviews this information to gather additional information. The Industry if determine there has been a change basis. to the price Basis Changes to the Price f a sample, some changes to the same e exact the life o item during While we try to price th p rice basis are inevitable. Common exa mp les of changes include: • An item is discontinued and with another; fo r example, a certain airline flight replaced laces it with a different route between two cities has been discontinued but the airline rep between other cities. • A product is physically changed; for example, a piece of l uggage has its v iny l trim replaced with l eather. • The terms of transaction are changed, with o r without a chan ge to the product; for example, a m anuf acturer had b een reporting a price for sale of 100 desks as part o f a long g a price for the spot sale of term contract but the contract expired and she now is reportin a single desk. 1

2 It is important to note th at not anges to an item resu lt in changes to the price basis. all ch For ex ample, a change to an item’s name or model number with no co rresponding change to the physical product would not be considered a change to the price basis. st determines there has been a change to the Price B asis, the Analyst If the Industry Analy decides the best app reflects only pure price change based on roach to ensure the PPI market factors. Methods of Quality Adjusting When a change to the price basis does occur, the Industry Analyst has a range of quality adjustment meth ods available to isolate any from price change due to the pure price change change in price basis. The most appropriate ds on the type of change and the method depen information available from the respondent. At the most basic level, PPI indexes are calculated using the following ratio: / (N)PriceNet (N)PriceBase 1) - (N Price Base / 1) - (N PriceNet An item’s initial base price is the price that was in effect in the first month a price was an item’s product collected. Note that if specifications and ged terms of transactions are unchan from that first month, th e base price for N an same. All of the quality adjustment d N-1 are the th e current month’s base p he net price and base price used for each rice so t methods modify the same price basis even month represent if there is a change between months. The standard methods of quality adjustment available are: Explicit quality adjustment In most cases, explicit quality adjustment is the preferred method of quality adjustment. It is used when there is a known change to an ite m and the respondent can provide the production cost differences (marked up to selling price) of the change. By modi fying the current month base price to account for the pr oduction cost differences, the curre nt and previous month ratios can be compared and only price change that is market–related and not due to the change in the item will be reflected in the index. For example, assume a respondent had been repor ting a price for a table made from pine wood. The table top was changed to use oak wood and the price was raised from $175 to $200. Also assume that the base price for the pine topped table was $150 before the top was changed to oak wood. The respondent noted the change to th e table raised producti on costs $20 dollars. Consequently, the entire price change was not pur e price change. The PPI will adjust the base due to product change (change in inputs) as a price and not show the proportion of the change price increase. 2

3 The formula for an explicit quality adjustment is: New Base Price = (Old Base Price (N -1) * New Price (N))/(New Price (N) – VQA)) New Base Price = ($150*($200/($200-$20)) = $166.67 Where: Old Base Price (N-1) = Previous month’s base price for the item before the change, ($150) New Price (N) = Current month’s net price for the item after the change, ($200) VQA = The value of the quality adjustment, the production cost change due to the change in the item, ($20) In this example, if the Base Price were not adjusted, this ite m would have shown a 14% price increase, but with the adjustment th e item shows a 3% price increase. Overlap Unfortunately, it is not always possible to obtain the production cost differences associated with a change to an item. In some cases, the re spondent is unable or unw illing to provide that information. If the item with the new price basi s had previously been available, we can use the overlap method . This would be the case if an item was discontinued and replaced with a previously available item. Using this method, prices for the new price basis in the previous month are compared to prices for the old price basis in the previous month. Price change reported on the old price basis is tracked thr ough the overlap month and price change reported on the new price basis is followed beginning in the overlap month. For example assume a respondent discontinued the $3,200.00 hot tub we had been pricing. He agreed to price a different hot tub with more features that sold for $4,600.00. The new hot tub had been available for several months but he co uld not provide the production cost differences between the two hot tubs. In this case, we would use the overl ap method and compare the price of the old hot tub with that of the new hot tub in the last month they were both available. Assume the Base price was $2,800.00 prio r to the change in hot tubs. The formula for the Overlap Method is: New Base Price = ((Old Base Price (N-1) * New Price (N-1)) / Old Price (N-1)) New Base Price = (($2,800 * $4,600) / $3,200) = $4,025.00 Where: Old Base price (N-1) = Previous month’s base price for the item, ($2,800) New Price (N-1) = Previous month’s net price for the new item, ($4,600) Old Price (N-1) = Previous month’s net price for old item, ($3,200) In this example, if the Base Price were not adjusted, this ite m would have shown a 44% price the item shows no price increase. increase but with the adjustment 3

4 Ratio method The ratio method is a simple method to account fo r changes in the quantity of an item included is modified by the ratio of the new size to the in the price basis. The current month base price old size. It is best used when ec onomies of scale are not present. For example, assume a respondent changed the size of a jar of spaghetti sauce from 22 ounces to 20 ounces but did not change the price of $2.11. In this case, we would adjust the base price by the ratio of the new and old sizes. Assume the Base Price had been $1.89 prior to the change in jar size. The formula for the Ratio Method is: New Base Price = (Old Base Price (N -1) * New size (N) / Old size (N-1)) New Base Price = ($1.89 * 20 / 22) = $1.7182 Where: Old Base price (N-1) = Previous month’s base price for the item, ($1.89) New Size (N) = Current month’s size, ($20) Old Size (N-1) = Previous month’s size, ($22) In this example, if the Base Price were not adjusted, this ite m would have shown no change in price, but with the adjustment th e item shows a 10% price increase. Link to the cell relative ndustry Analyst can perf orm a link to the cell When no other information is available, the I relative. This would be done if no explicit quality adjustment information is available and the item was never available at the same time with both the old and new price basis. This method change in the month of the price basis change adjusts the base price so the item shows a price price change for similar items (those in the homogeneous index that is equal to the average ‘cell’) with good reported prices. For example, a respondent discontin player that she had priced ues the clock radio with a cassette for the PPI and shifts all of he r production to IPod docking stations . She agrees to price an IPod docking station but there is no overlap peri od and she cannot provide the production cost differences. Assume the clock radio sold for $42.00 and had a Base Price of $39.00. The IPod docking station sells for $64.00. The formula for a link to the cell relative is: New Base Price (N) = ((Old Base Price (N-1) * New Price (N)) / Cell Relative Price (N)) New Base Price (N) = (( $39.00 * $64.00) / $42.84) = $58.2633 Where: Old Base Price (N-1) = Base price for the old item in N-1, ($39) New Price (N) = Net price for the new item in N-1, ($64) the Old Price by the Cell Relative Price (N) = is a price calc ulated by adjusting price movement of the item's cell. In this example assume the IPod docking station cell showed a 2% increase, ($42 * 1.02 = $42.84). 4

5 In this example, if the Base Price were not adjusted, this ite m would have shown a 52% price e item shows a 2% price increase. increase, but with the adjustment th Special cases Specialized techniques that use h edonic regressions and external data have been section provides incorporated into on th ese special cases. the PPI. This information the characteristics of an item an d its price. Hedonic regressions estimate the relationship between These r yield estimates of "implicit prices" for specified item characteristics which egressions e the quality may be used to valu from changes to the item. The value of improvement resulting removed from the reported price change to obtain a the q uality improvement can then be measure of the pure nic regressions work well in indu stries with rapid price change. Hedo technological change where quality changes are not directly related to production costs such as computers. Since hedonic regressions requir e complex modeling, they are not attempted on a case by case b established as a procedure for certain product areas. For detailed asis but are PPI program’s use of hedonic g article, er to the followin information on the modeling, please ref onic Models in the Producer Price Index. Hed for several service in dustries that lack sufficient quality adjustment data at the Additionally, company l evel, data can be obtained from an external source to determin e the VQA for explicit quality a djustment. These i following: ndustries include the Private passenger auto insurance  General medical and surgical hospitals   Nursing care facilities 1 Private passenger auto insurance For insurance, the output measured is the assump tion of risk and financial intermediation. The challenge in pricing this output over time is identifying and adjusting for changes in risk. For changes in explicitly endogenous ri sk factors such as changes in coverage, insurance companies have suitable cost data to allow for meaningful cost-based quality adjustment. However, for changes in exogenous risk factor s that go beyond the scope of polic y negotiations, such as an data would not be suffi increased incidence of theft, company-specific cient to definitively quantify risk. 5

6 For pricing private passenger auto insurance, the age of the insured auto must remain constant to a constant real level for the dura assure that its value remains at tion of the pricing period. Risk changes occur even though the age of the insured auto remains the same. To keep the age constant, the model year of the auto is updated on ce a year to the next model year. For example, a 1996 Honda Accord is changed to a 1997 model in the subsequent year. However, changing the model year can also move the auto into a different risk category known as a symbol group. Insurance companies are unable to assess this ri sk change on their own, but a valuation can be obtained from the Insurance Services Office (IS O). This organization pools risk information industry-wide, producing data whic h are broader in scope than a ny one company could gather on its own. The ISO assigns autos to symbol groups ba eristics. For the PPI sed on their risk charact program’s purposes, the ISO provide s the value of risk change for every auto included in the index. The ISO monitors the symbol group that is assigned to an auto and the particular risk associated with that symbol group. When an au to moves into a different symbol group, ISO assigns a value to the risk change that occurs. This value is then used to explicitly quality adjust the premium used in the PPI. Therefore, the risk changes are not reflected in the index as pure price changes. 2 General medical and surgical hospitals als measures the monthly change in prices The PPI for General medical and surgical hospit received by hospitals for the prov s. The provision of care is ision of medical care to patient delivered through various i nputs including, but not limited to, many types of surgery, pharmaceutical treatments (aspirin, antibiotics, etc.), assessments of bodily functions, and rehabilitation and counseling from professional health care staff. A concern in pricing hospitals is the change in treatments over time. Improvements in medical technology, new procedures, or new drugs can imp act treatments in terms of the length of hospital stay, the types or amount of drugs administered, or treatment outcome. It is difficult to determine when such a change is a change in quality or a pure price change. A price change associated with a change in treatment that result s in the same outcome would be treated as a pure veloped with substantial differences in outcome, price change. However, if a new treatment is de a quality adjustment may be warranted. An exampl e is replacing a surgical treatment with a drug treatment that produces a different outcome. The Department of Health and Human Servic es’ Hospital Compare (HC) database captures changes in inputs that either indi cate or serve as proxies for changes in health quality measures. The PPI program uses these measures to estima te an explicit value of quality adjustment for items priced in the General medical and surgical hospitals index. For more information on PPI ral Hospital Producer Price hospital quality adjustment, refer to Proposal for Adjusting the Gene . Index for Quality Change 6

7 3 Nursing care facilities the care and services provided to residents, The primary output of nursing care facilities is staff. Any changes in staff intensity per largely through inputs represented by the nursing resident per day may indicate a ch ange in output quality. To meas ure this change in quality, PPI staff adjusts items based on one of the quality indicators published by the Department of Health try. The quality indicator meas and Human Services for that indus ures changes in nurse staffing levels for each nursing home. A positive corre lation between nurse staffing levels and the quality of services provided by nursing homes was demonstrated before any steps were taken to quality adjust the nursing care facilities inde x . While nurse staffi ng is only one of many complex factors that impact th e quality of nursing care faciliti es services, analyses by the Institute of Medicine (IOM), the Centers for Me ices (CMS), and the dicare and Medicaid Serv General Accounting Office (GAO) point to nurse staffing as a key factor in determining the quality of nursing care facilities care. A dollar value is assigne d to changes in nurse staffing levels using mean wages calculated by the BLS Occupational Employment Statistics program. More Information For detailed i nformation on PPI m ethodology in g eneral, including quality adjustment an d index calculatio n formulas, please see th e C hapter 14 of the BLS Handbook of Methods that covers Producer Prices. U.S. Bureau of Labor Statistics Producer Price Index August 2014 1 th for Non-Life Insurance” (Paper presented at the 26 Bathgate, Deanna, “United States Producer Price Indexes Voorburg Group Meeting on Services Statistics, September 19 – 23, 2011), http://www.voorburggrou p.org/Documents/2011%20Newpor t/Papers/2011%20-%2036.pdf 2 Hospital Quality Valuation Team. U.S. Bureau of Labor Statistics, “Proposal for Adju sting the General Hospital Producer Price I ndex for Quality Change,” (Paper presented at the Institute Conference on Research in Income and National Bureau of Economic Research Summer Wealth, July 14, 2008), http://conference.nber.org/conf er/2008/si2008/PRCR/murphy2.pdf 3 Agliata, Michael and John Lucier. “Appendix: The Effect of the New Qua lity Adjustment Methodology for Nursing Home Price Indexe s.” th Voorburg Group Meeting on Services Statistics, September 15, 2004), (Paper presented at the 19 20ottawa/papers/2004-051.pdf h/voorburg/documents/2004% http://stds.statcan.ca/englis 7

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