Hedonic price indexes and the distribution of buyers across the product space: an application to mainframe computers

It is now a common practice to adjust prices for changes in quality for products that undergo signi® cant quality change from one year to the next. According to Berndt (1991), the ® rst attempt to do so was by Waugh (1928) in his study of intraday vegetable prices. Soon thereafter, Court (1939) applied this `hedonic pricing’ to automobile prices to demonstrate that quality-adjusted prices for autos were declining even though the nominal prices for autos appeared to be skyrocketing. From this point on, hedonic pricing and hedonic price indexes became associated with adjusting prices for product quality change. The application of hedonic pricing to computers began with Chow (1967). He showed that the quality-adjusted price for computers declined nearly 21% per year from 1960± 65. Since then, numerous studies have estimated price indexes for mainframe and personal computers, using various time periods, data sources, and regression speci® cations (see Triplett (1989) for a review of these studies). Most recently, Caudill and Gropper (1997) estimated that the quality-adjusted price for mainframe computers fell 16± 20% per year from 1984± 1994. The majority of studies in this ® eld have chosen a log-log functional form for the speci® cation of the hedonic price function. In addition, all of the studies have used data on the systems available for sale. In other words, data sets in previous studies have consisted of single observations for each system available for sale in the market. More importantly, these observations did not include any information on the number of systems that were actually purchased in the market. This type of data along with the log-log functional form has the e ect of estimating the frontier of the product space assuming that buyers are distributed uniformly across the product space. Using data on 21 268 mainframe computer purchases that took place between 1984 and 1994, this study demonstrates that buyers are not uniformly distributed across the product space in the mainframe computer market and that the skewed distribution of buyers in this market implies a much slower rate of quality change than the traditional hedonic approach implies. This result is important when considering the `Boskin Commission’s’ report (Boskin, et al., 1996) to the US Senate Finance Committee in 1996. The Boskin Commission was created by the US Senate Finance Committee to study the sources of possible bias in the consumer price index (CPI) and investigate the impact of such biases on government bene® t programmes, such as Social Security. The commission argued that the CPI overstates the annual change in the cost of living. One of the biases noted in the report was the so-called quality-change bias. This is the bias that occurs as a consequence of the (mis)measurement of quality change over time. The results in this paper suggest that this bias may be signi® cant for components of the CPI that undergo signi® cant quality change and have a skewed distribution of purchases across the product space. This is because some of these compon-