New products and price indexes.

• Author: Hausman, Jerry A.
• Position: Relation between new products and consumer price indexes

What is the value to consumers of new products? The number of new products introduced in any year is astounding. New varieties of consumer goods such as cereal brands are evident, as any shopping trip to a local supermarket or Wal-Mart demonstrates. Potentially even more important are the new products based on technology: more than 55 million cellular telephones are in use in the United States, and more than 20 million people subscribe to the Internet, for example. Does consumer welfare increase significantly with these new goods and services? If so, then the Bureau of Labor Statistics (BLS) is likely miscalculating the consumer price index (CPI), because the CPI does not take into account the value to consumers of new goods and services.

The economic theory behind the CPI is well developed. The CPI approximates an ideal cost-of-living index (COLI) which, in turn, tells us how much more (or less) income a consumer would need to be as well off in Period 1 as in Period 0 given changes in prices, changes in the quality of goods, and the introduction of new goods (or the disappearance of existing goods). The omission of the effect of the introduction of new goods in the CPI seems quite surprising since most common business strategies fall into one of two categories: either become the low-cost producer of a good just like your competitors' or differentiate your product from theirs. The latter strategy has become the hallmark of much of American (and Japanese) business practices. The sheer number of brands of cars, beer, cereal, soda, ice cream, yogurt, appliances such as refrigerators, and cable television programming all demonstrate the ability of firms to differentiate their products successfully. Furthermore, consumers demonstrate a preference for these products, because they buy enough of them that businesses make the expected positive profits on the new brands.

In my first paper on this subject,(1) which considers new cereal brands, I find a significant consumer value placed on new goods. This value may cause the CPI to be seriously overstated, since it neglects new products. In the paper, I first explain the theory of cost-of-living indexes. Then, using the classical theories of Hicks(2) and Rothbarth,(3) I demonstrate how new goods could be included. The correct price to use for the good in the pre-introduction period is the "virtual price," which sets demand equal to zero. Estimation of this virtual price requires estimation of a demand function, which in turn provides an expenditure function...