The Consumer Price Index (CPI) is a macro-economic measure of the prices paid by households for the goods and services they purchase. Changes in the CPI from one quarter to the next provide a measure of the rate of inflation for Australian households. As a measure of inflation, the CPI measures pure price change over time, reflecting the change in the cost of buying a ‘fixed basket’ of goods and services of constant quality. Pure price change is the change in the price of a good or service of which the characteristics (quality) are unchanged; or the change in the price after adjusting for any change in quality.
While the CPI is often thought of as a fixed basket, in practice the CPI basket is updated in two ways:
- Each year the CPI is re-weighted to capture changes in the purchasing patterns of Australian households.
- Goods and services (or items) exit the basket every quarter and are replaced by new items.
Items are replaced in the CPI basket for a range of reasons, including: a new model replacing an older model, the item is no longer available or consumer preferences have changed.
As these new items have different characteristics, or ‘quality’, compared to their predecessors, it is necessary to remove any change in price that is attributable to the change in quality.
Capturing quality change in the CPI is also important for other economic statistics, such as Gross Domestic Product (GDP). Failure to adequately account for quality change in the CPI (or any price index) could lead to a bias in GDP. An increase in quality can be thought of as an increase in economic production. With price indexes being used for deflation purposes when measuring GDP, a bias in the CPI would also have implications for measurement of real GDP. In this sense, a change in quality needs to be captured in the CPI so that it is accurately reflected as a change in production when measuring GDP.
This article explains quality adjustment in practice and provides examples of the methods used by the Australian Bureau of Statistics (ABS).
Quality change in practice
The ABS uses a range of techniques to adjust for changes in quality, with quality adjustments being applied to 2-3 per cent of sampled items each quarter. This equates to around 2,000 quality adjustments out of the 85,000 items priced in the CPI each quarter (footnote 1). In addition to this, quality change is captured automatically in the case of telecommunication services, which is discussed in more detail below.
The prevalence of quality adjustments differs across the CPI. Chart 1 lists the average proportion of quality adjustments relative to the sample size for each CPI group. Chart 1 shows that quality adjustments are more prevalent in items for clothing and footwear; housing; and furnishings, household equipment and services. Quality adjustments are less prevalent for alcohol and tobacco; and insurance and financial services.
The product range for goods such as clothing, furniture and electrical appliances is continually refreshed and updated. This is often referred to as ‘product churn’. These changes in quality require the application of quality adjustments to ensure the CPI measures pure price change. On the other hand, product churn for goods such as food, alcohol and tobacco, isn’t as frequent, meaning that the same quality items are available for a longer period of time.
Quality adjusting services
Adjusting for quality change is inherently more difficult for services than goods. Estimating the value of the quality change is easier for goods where, for example, the packet size has changed or there are additional features available, such as satellite navigation in motor vehicles. For services however, the quality change is more subjective and less obvious, which makes it more difficult to estimate the value of quality change.
In the case of services, adjustments for quality change are made where the value of the change can be quantified. However, the ABS acknowledges that some quality change in services (both increases and decreases) cannot be quantified and therefore are not captured in the CPI.
One example is airfares, where comfort and in-flight entertainment have improved in many cases. However, it is not possible to easily quantify this improvement in order to apply a quality adjustment in the CPI.
Another example is child care, where new legislation has mandated higher qualifications for carers and increased the ratio of carers to children. Again, no quality adjustment was made to reflect this quality improvement.
Quality adjustment case studies
Quality change takes many different forms, with differing impacts on the range of items in the CPI. Some items may improve in quality with new features or better services, while others may decrease in quality, such as smaller package sizes or fewer features.
Chart 2 shows the price change over the past three years of some products in the CPI that experience substantial quality change. The price change in Chart 2 is after adjusting for quality change and is what is used when measuring the CPI. The following section discusses how quality change is captured for each of these products.
Quality change from variations in plan inclusions by telecommunication service providers are automatically captured through change in usage. For example, if the level of service increases, demonstrated by increased mobile downloads, and the price does not change, this will be reflected as a price fall in the CPI. The majority of the 12 per cent price fall over the past three years for telecommunication equipment and services has been due to an increase in quality for the service component, where providers compete heavily on mobile download limits. Essentially, consumers are receiving a greater level of service for an equal or lower price.
Audio visual equipment
Quality adjustment is applied to new items (e.g. televisions and computers) after comparing the features in the original and replacement item. Examples of changes in quality includes screen size, screen resolution, memory and energy efficiency. Product churn is very prevalent for these items, with old models being replaced by new models frequently.
Quality adjustments are applied to the reported price of the vehicle where there have been changes in the characteristics in terms of motoring performance, fuel economy, safety features or other enhancements. The approach used in the CPI is to estimate the value of the quality change based on the views of a panel of experts (footnote 3). This approach aims to estimate the average value of the quality change from the consumer’s perspective.
Quality change occurs in both directions. Understandably, there is greater awareness of quality increase where technological improvement results in a quality adjustment being applied to show a price fall in the CPI. Examples where this occurs include audio visual equipment and motor vehicles. What is less noticeable are the quality adjustments that are applied to items that have shown a quality decrease. In this case, a price rise is recorded in the CPI.
A well-known example of a quality decrease is where the quantity (or volume) falls but the price remains the same. This is known as ‘shrinkflation’ and is particularly prevalent in food items. When the volume falls but the price remains the same, consumers are essentially paying the same price for lower quality.
The use of transactions ‘scanner’ data in the Australian CPI, which provides detailed item information, enables the ABS to identify and adjust for quality change arising from shrinkflation. The following provides a worked example of how shrinkflation is accounted for in the CPI.
- The observed price of a drink remains at $3.00 over three periods. However, the volume of the drink falls from 750ml to 675ml. If no quality adjustment is made, there will be no price change recorded in the CPI.
- To apply an adjustment, a quality adjustment factor is calculated by expressing the change in volume as a percentage. In this case, the volume has fallen by 10 per cent (675/750 – 1) and the factor equals 1.1 (1+10%).
- The factor of 1.1 is applied to the period 3 observed price to calculate a quality adjusted price of $3.30 ($3.00 x 1.1).
- The adjusted price is used to calculate a price increase of 10 per cent ($3.30/$3.00 – 1). The price increase of 10 per cent is then used in the CPI.
Table 1: Shrinkflation example
|Period 1||Period 2||Period 3|
This CPI explainer highlights the importance of adjusting for quality change in the CPI in order to produce an accurate measure of household inflation. While adjusting for quality in the CPI is challenging in a lot of cases, the ABS uses a range of techniques to identify and quantify quality change.
For more information on quality change in the Australian CPI, see the chapter Quality Change and New Products in the CPI Concepts, Sources and Methods manual (cat. No. 6461.0).
- For the 85,000 items sampled in the CPI, upwards of 1 million prices are collected each quarter.
- Chart 1 excludes the quality change that is automatically captured for telecommunication services, which contributes 80 per cent of the weight of the Communication group.
- This internationally recognised approach is known as the ‘Delphi method’, which uses a panel of experts who each provide their estimated value of the quality difference. The median is taken of these estimates and any estimate that is considered extreme is sent back to the expert concerned, who is asked to account for possible reasons behind the difference.