Why Hedonic Quality Adjustments Are Invalid

Quality changes can only affect relative prices, not overall price levels if the supply of goods, the supply of money, and the demand to hold money are all held constant.

Assume that a closed economy has only 10 goods, and that the ONLY change over the next year is an improvement in quality for each of the 10 goods. For simplicity assume that all 10 goods are packaged in such a way so that they all have the same price.

Assume that the improvements in quality are determined in the following way:

Start by dialing up the quality of all 10 goods by 10%, or by what seems like 10%, it doesn't matter.

Go back and adjust the individual good quality levels recursively until all 10 goods have the same market price.

With no change in the number of goods, or the supply and demand for money, the 10 new prices will be identical to the prices that existed before the quality of the goods was increased.

We have a substantial increase in the standard of living due to the increased quality of goods, but the prices and the cost of living are unchanged.

This is an inherent flaw in the use of hedonic quality adjustments, and, in fact, if hedonic adjustments didn't result in an understatement of the price effects of monetary supply inflation, you can bet that the government wouldn't make use of them as it attempts to reduce future COLA adjusted outlays.

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