Hedonic adjustments over long periods of time

In The Second Machine Age, Erik Brynjolfsson and Andrew McAfee capture the GDP effect of some technological progress as the price of a good falling from infinity to zero. This might get the supply-side tension right, but there are a few other problems in measuring long-term changes in standard of living. This post is a question more than answer and one that touches on interesting aspects of the debate on unmeasured consumer surplus, magnitude of economic wellbeing, and secular stagnation.

As a baseline, consider the BLS method of hedonic adjustment. To account for changes in product quality, they generate a regression of log price on various attributes (for example pixelation and screen size for television). They then consider improvements in these factors over time to make sure estimated inflation doesn’t overstate the truth.

This gets the year-on-year figures right, but makes long-term adjustment really hard. Specifically, consider your Internet service that’s probably too expensive. Hedonic adjustments will adjust for increases in speed, at least at a first order. Now of course, the consumer Internet didn’t exist in 1980 and therefore it’s theoretical price was infinite.

But suppose you could move the Internet back to 1980. Everything. Routers, telecom wires, transpacific cables, etc. The market price of this service would be next to nothing, since no one has computing technology to browse the web, since no engineers exist to create worthwhile content, and since building the necessary infrastructure from the state of science at that point in time is extremely hard.

In that sense, the shadow market price of the Internet that doesn’t exist yet is 0. This isn’t true for all technology. Shoes today are way better than shoes in 1980, and even if the technology didn’t exist to create them as we do now, the market price would still be far greater than that for the 1980 equivalent.

This framework as easily suggests there was massive deflation in the price of shoes (which is true) and a massive inflation in the price of Internet (which is false).

Our examples don’t need to be so extreme. An iPhone would be considered vaguely useful as a portable camera, but without technology to listen to music it wouldn’t be nearly as popular as it is today. Still it’s an incredible product and well-above its time in technology and should command a premium (this is the entire argument of a hedonic adjustment). And this of course assumes a stability in tastes and preferences.

This is intimately connected to the question of consumer surplus. It’s frequently said that productivity improvements are underestimated given the “explosion” of consumer surplus from web services like Netflix, Google, and Facebook – “how much would you pay for Facebook”, the question goes. Still it’s unlikely that this surplus actually goes unmeasured. I almost certainly wouldn’t pay $100/mo for LTE data on my iPhone if I couldn’t access Facebook, Google, or iMessage. Without considering the cross elasticities between free products, and the new industries they tempt, it’s hard to argue that GDP is underestimated relative to the true economic benefit.

Consider clean air. One day China will have a technology that cleans its air despite extremely intense energy consumption, and it will be extremely cheap relative to the life and economic savings it generates. Its creator will be praised for creating all sorts of consumer surplus unmeasured in China’s GDP. Unmeasured except for the boom in foreign investment, outdoor playgrounds, and botanical gardens that is.

Arguing that we didn’t have Netflix or Google in 1980 isn’t enough. We pay for Comcast and Apple, which are both prominent in GDP numbers. Of course this doesn’t say much about the distribution of that surplus – it might be that this benefits certain percentiles more than others, but this isn’t an easy claim to make without reference to the relevant cross elasticities of demand.

Does this mean inflation isn’t transitive? How would we model that? An error term that grows unreasonably when considering changes over decades or more?

It might be that the right answer is extremely large standard errors in estimates of long-term inflation. As certain markets grow large at the expense of others – cars versus cabs, for example – the statistical basis for making hedonic adjustments against an increasingly non-representative base challenges statistical conviction.

This is relevant in finance as well. 30 year Treasuries price in some expected degree of inflation. But the annualized inflation rate is likely very different from the true inflation, even though it’s correct on a year-on-year basis. Moreover, to the extent inflation is low from hedonic adjustment, it is because of a dramatic increase in the real growth rate.

Is there another premium in long-term bonds? A term premium yes, but also a “hedonic error premium” – which would include the expected inflation as measured (i.e. the breakeven rate) along with the error term that is larger in 30 years than it is in 10 years?

We could have a market for how much better 2015 is than 2014. We don’t have a market for how much better 2015 is than 1800. A diligent team of investors could answer the question “how much would you have to pay me to use 2010 healthcare instead of 2015 healthcare”. It’s not clear the same team could answer the question “how much would you have to pay me to use 1980 healthcare instead of 2015 healthcare” (a question posed by Larry Summers to suggest there is unmeasured productivity improvement since 1980).

Or it could just be that the existence of old age dating apps and the Internet makes being 85 much more tolerant – and the consumer surplus of the needless to say cheap apps is masked in elderly healthcare costs.

Now this isn’t to say technological progress is underrated in its contribution to humanity. If anything we probably owe earnings growth in legacy industries to technological surplus.