Prices, productivity, and innovation.

• Author: Weinstein, David E.
• Position: Research Summaries

Economists have long known the importance of focusing on "real" as opposed to "nominal" variables in order to understand a wide range of economic outcomes including growth, productivity, and welfare. While the distinction between real and nominal variables is simple in theory, in practice it is very difficult for statistical agencies to measure prices accurately. One of the main problems is that the set of goods in the economy is constantly changing because of the creation of new goods and quality upgrading. How can we measure price changes when the set of goods consumed in two periods is different? Much of our research over the last few years has focused on estimating the impact of new goods on our understanding of the U.S. and world economies.

A hallmark of our approach has been to combine micro data with a rich framework that allows the biases in the price measurement of individual goods to be aggregated over large sectors of the economy. This research has produced a series of papers that have emphasized the macro implications of these micro biases. The principle macro implications of our work are:

* Because trade provides consumers with new goods, we have underestimated the gains from globalization around the world over the last few decades. (1)

* We estimate the aggregate CPI bias for a large set of goods to be close to 1 percentage point per year and to have a strong pro-cyclical component. The cyclicality of the bias suggests that business cycles are more pronounced than is typically reported in official statistics. (2)

* Incorporating the effect of new goods into the measurement of prices suggests that real wages for the typical worker in the United States have risen substantially over the last 30 years. It also suggests that poverty rates based on our corrected CPI measurements have fallen sharply since the late 1960s relative to their official counterparts. (3)

New Goods and Inflation

The starting point for thinking about how new goods and higher quality goods affect price measurement is an understanding of how prices are currently measured. Virtually all price indexes used by economists are essentially "common goods" price indexes. In other words, most of these indexes compare the prices of a common set of goods sampled in two periods and then take a weighted average of those prices to obtain a single estimate of inflation. In the case of the U.S. Consumer Price Index (CPI), we adjust a small subsample of the prices for quality changes (for example, computers), but in general no adjustments are made for the appearance of new goods.

The problem with this methodology is that the appearance of new goods has price implications for consumers. To understand this, one needs to think about how a new good affects a consumer. As John Hicks argued decades ago, the appearance of a new good can be thought of as a drop in the price of the good from its reservation price--that is, the price at which demand equals zero--to the observed market price. Since official price...