The Hedonic Pricing of Computers, Use and Misuse

So-called 'hedonic pricing' is used in an attempt to adjust the prices used in statistical studies for variations in the quality and characteristics of specific products for the purpose of calculating price inflation, and national GDP and Productivity growth.

Many believe that the inappropriate hedonic pricing of computers, especially in the latter half of the 1990's, has resulted in a substantial understatement of price inflation and also a substantial overstatement of the growth rates of both national GDP and Productivity.

As expected, the statisticians deny this, but their arguments tend to reveal a general ignorance or disregard of the true essential nature of economics. It is understandable that statisticians in particular, and mathematical economists in general, tend to concentrate on prices, the only numbers that can be aggregated across all the products and services that an economy produces. However, market prices are not a measure of economic value, but rather a means of balancing supply and demand. Market prices are a signal to both producers and consumers as to what actions are needed to best satisfy the subjective values of consumers, given the existing limited supply of economic resources available. Market prices also enable economic calculation, in which entrepreneurs competitively attempt to earn profits by better satisfying the future subjective values of consumers.

The market price of a product thus does not directly represent some intrinsic economic value, but rather is the result of a complex, interactive process. The part of this process that is involved with consumer demand results from the utility of the product in satisfying consumers, not some intrinsic characteristic of the product itself. Any good or product that exists in a surplus of supply quantity over that which can be utilized in the satisfaction of consumers has no economic value contained in that surplus. Similarly, changes in the characteristics of goods or products which cannot be connected to an increase of consumer satisfaction, also have no economic value.

To get a handle on the hedonic pricing of computers, I will quote small sections of the following paper :

A Note on the Impact of Hedonics and Computers on Real GDP (pdf), by J. Steven Landefeld and Bruce T. Grimm, in the December 2000 issue of Survey of Current Business.

What are hedonic price indexes?

Despite their unfortunate name, hedonic price indexes
are simply statistical tools for developing
standardized per unit prices for goods, such as
computers, whose quality and characteristics are
changing rapidly. Just as traditional price indexes
measure the change in the price of strawberries by
holding fixed the weight of the strawberries in a
box rather than by the price per box, computers
need to—at a minimum—be priced by holding
fixed the computing power in the computer box.

Discontinuities

In December 1985, BEA introduced quality-adjusted
price indexes for computers and peripherals
that were developed using hedonic techniques.
Prior to the development of the hedonic-based indexes,
the price index for computers was held constant
at the base period value of 100; this
treatment, which differed from that for most other
NIPA price indexes for goods, faced increasing
skepticism in a period of declining prices and increasing
capabilities of computers and computer
systems. Working with IBM, BEA developed hedonic
price indexes for computers and peripherals
that were designed to capture the equivalent of the
price per unit of computing power through the use
of multiple regressions that explained the differences
in the prices of computers and peripherals of
different types and vintages as functions of their
characteristics. The first index covered 1969–85,
and BEA later developed estimates back to 1959;
before 1959, computers were of little importance
and were not separately identified in the NIPA’s,
thereby minimizing the discontinuity.

There is little reason to quarrel with the idea that strawberries should be priced by weight for statistical purposes, and not by the box, if the content of boxes can vary.

Computers are not quite so simple. The time period over which the initial hedonic pricing of computers was done, i.e. 1969-85, was for all intents and purposes the pre-PC era, as the IBM PC only came into existence in 1981. In the 1970 era, the computer would typically be a mainframe computer, an IBM Model 360, for example, sitting in a central computer center and accessed by means of time-sharing keyboard printing terminals. For the purposes of this discussion, the computers would be accessible for most of a 24 hour period, as its expense would outweigh the cost of continuous staffing.

If we assume that a single mainframe computer model could service 25 simultaneously interactive users and execute some given workload of general computing, then servicing 50 simultaneous users and twice the workload would require a second computer. If one computer were to cost $5M, then two would cost $10M.

If a new model of computer is brought out that has twice the computing power and costs $10M, it is clear that it IS appropriate to adjust the price of a computer for its computing power so that the price of a computer does not appear to have doubled.

However, this is only true if the 50 user and double workload actually exists and is accomodated. If the computer is not run over the full 24 hour period or if 50 simultaneous users need not be accomodated. then the price of the computer has effectively doubled. The computer is the means to an end, not an end in itself. The value of the computer is the value of what it can and does accomplish, not what it might accomplish if only the demand for its services were greater.

While the expense of mainframe computers was so great that it would be expected that most of its computing power would be actually used to the extent possible, the opposite is the case for today's PC's. PC's are so inexpensive today that they can be justified just for the possibility that an expensive person might need to use one once a week.Over all the installations of PC's in the world today, the vast majority at any instant are either turned off or executing screen-saver functions. Even when they are actively being used by a human, the majority of computation cycles are expended waiting for keystrokes. Under these conditions, the vast majority of computation power is surplus to demand, and of no economic value. Thus, hedonically adjusting PC prices for increases in computing power is absurd.

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