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 Measuring Globalization

Volume 1

Houseman and Mandel Vol1.indb i 2/16/2015 8:30:54 AM

Houseman and Mandel Vol1.indb ii 2/16/2015 8:31:30 AM
 Measuring Globalization
Better Trade Statistics
for Better Policy

Volume 1
Biases to Price, Output, and
Productivity Statistics from Trade

Susan N. Houseman
and
Michael Mandel
Editors

2015

W.E. Upjohn Institute for Employment Research

Kalamazoo, Michigan

Houseman and Mandel Vol1.indb iii 2/16/2015 8:31:31 AM

 Library of Congress Cataloging-in-Publication Data

Measuring globalization : better trade statistics for better policy / Susan N. Houseman
and Michael Mandel, editors.
volumes cm
Includes bibliographical references and indexes.
ISBN 978-0-88099-488-0 (v. 1 : pbk. : alk. paper) — ISBN 0-88099-488-6 (v. 1 :
pbk. : alk. paper) —ISBN 978-0-88099-489-7 (v. 1 : hardcover : alk. paper) — ISBN
0-88099-489-4 (v. 1 : hardcover : alk. paper)
1. Commercial statistics. I. Houseman, Susan N., 1956- II. Mandel, Michael J.
HF1016.M44 2015
382.01'5195—dc23
2014047579

© 2015
W.E. Upjohn Institute for Employment Research
300 S. Westnedge Avenue
Kalamazoo, Michigan 49007-4686

The facts presented in this study and the observations and viewpoints expressed are
the sole responsibility of the authors. They do not necessarily represent positions of
the W.E. Upjohn Institute for Employment Research.

Cover design by Alcorn Publication Design.

Index prepared by Diane Worden.
Printed in the United States of America.
Printed on recycled paper.

Houseman and Mandel Vol1.indb iv 2/16/2015 8:31:32 AM

 Contents

Acknowledgments vii

1 Introduction 1
Susan N. Houseman

Part 1: Trade-Related Biases to Price Indexes: Theory

2 Sourcing Substitution and Related Price Index Biases 21

Alice O. Nakamura, W. Erwin Diewert, John S. Greenlees,
Leonard I. Nakamura, and Marshall B. Reinsdorf

3 Assessing Price Indexes for Markets with Trading Frictions: 89

A Quantitative Illustration
Brian K. Kovak and Ryan Michaels

4 Specific Trade Costs, Quality, and Import Prices 121

Benjamin Bridgman

Part 2: Evidence of Biases to Statistics and Measuring Industry

Competitiveness

5 Measuring Manufacturing: How the Computer and 151

Semiconductor Industries Affect the Numbers and Perceptions
Susan N. Houseman, Timothy J. Bartik, and Timothy Sturgeon

6 Import Sourcing Bias in Manufacturing Productivity Growth: 195

Evidence across Advanced and Emerging Economies
Robert Inklaar

7 Biases to Manufacturing Statistics from Offshoring: Evidence 219

from Japan
Kyoji Fukao and Sonoe Arai

8 Import Allocation across Industries, Import Prices across 251

Countries, and Estimates of Industry Growth and Productivity
Jon D. Samuels, Thomas F. Howells III, Matthew Russell, and
Erich H. Strassner

Houseman and Mandel Vol1.indb v 2/16/2015 8:31:32 AM

 Part 3: Eliminating Biases: Proposals to Improve Price Statistics

9 The Impact of Globalization on Prices: A Test of Hedonic Price 293

Indexes for Imports
Mina Kim and Marshall B. Reinsdorf

10 Producing an Input Price Index 331

William Alterman

Authors 359

Index 361

About the Institute 381

vi

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 Acknowledgments

This book and its companion volume are the culmination of a research
and conference project to document data gaps and biases in national statistics
arising from the growth of globalization and to propose solutions for statistical
agencies. We are indebted to the members of our advisory committee—Bill
Alterman, Carol Corrado, Richard Freeman, David Friedman, Mike Horrigan,
Ron Jarmin, Brad Jensen, Marshall Reinsdorf, and Marcel Timmer—who pro-
vided guidance on research topics and authors for commissioned papers as
well as on directions for future research. We thank Mike Horrigan and the U.S.
Bureau of Labor Statistics for hosting a preconference meeting, Diana Carew
for organizing the final conference, and Lillian Vesic-Petrovic for providing
outstanding research assistance.
The work for this project was supported by a generous grant from the
Alfred P. Sloan Foundation.

vii

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Houseman and Mandel Vol1.indb viii 2/16/2015 8:31:34 AM
 1
Introduction
Susan N. Houseman
W.E. Upjohn Institute for Employment Research

Economic and trade liberalization in developing countries, coupled

with technological advances that have greatly lowered trade and commu-
nication costs, have fueled an explosion in the volume of international
trade since the 1990s. Trade liberalization and technological advances
also have enabled a tremendous expansion in the types of international
transactions, including trade in services and intangibles and the devel-
opment of complex global supply chains. The accompanying expansion
of multinational companies has blurred the boundaries of national econ-
omies, and the production of manufactured goods and some services
increasingly has shifted to emerging economies. While international
trade in goods and services has long been expanding, the speed and
scope of recent changes have given rise to the term “globalization.”
Among the most pressing policy questions in the United States and
other advanced economies are those concerning the impact of global-
ization: Has globalization fostered productivity growth and well-being
in advanced economies? Or have the forces of globalization weakened
key national industries, resulted in widespread worker dislocation and
wage stagnation, and worsened inequality? Understanding the impacts
of globalization is critical to fashioning appropriate policies in a rapidly
changing world. But understanding its impacts requires good data, and
national statistical systems were not designed to measure many of the
transactions occurring in today’s global economy.
The chapters in this volume and its companion, Measuring Global-
ization: Factoryless Manufacturing, Global Supply Chains, and Trade
in Intangibles and Data, identify biases and gaps in national statistics,
examine the magnitude of the problems they pose, and propose solu-
tions to address significant biases and fill key data gaps. The chapters
originally were presented as papers at a research conference in 2013
funded by the Alfred P. Sloan Foundation, and their authors include

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 2 Houseman

researchers from academic institutions and statistics agencies in the

United States and other countries.
Shifts in the location of production and associated trade patterns
have been driven to a large degree by lower prices in emerging econo-
mies. The research in this volume focuses on biases in price indexes
that may arise from the growth of globalization, building on work pre-
sented at an earlier Sloan-funded conference in 2009.1 Price indexes
likely fail to capture price drops that consumers and businesses enjoy
when they shift purchases to lower-cost foreign suppliers—a gen-
eral problem termed “sourcing substitution bias” that results in an
understatement of real import growth and an overstatement of real
gross domestic product (GDP) and multifactor productivity growth.
Another source of bias arises from the fact that the use of imports in
the economy is not tracked. Errors in the allocation of imports to indus-
tries and final consumption, which is required in the construction of key
industry statistics, may have become more important as the volume and
uses of imports in the United States and other advanced economies have
grown. Such errors can lead to biases in input price indexes and asso-
ciated biases in measures of real output and productivity growth. The
decline of transportation costs also may have imparted a bias to price
indexes for imports, particularly low-cost imported products.
Another source of bias to price indexes may arise when price
changes associated with a new product or model are not observed.
To avoid such biases for domestic product prices, the U.S. Bureau of
Labor Statistics has used hedonic indexes to adjust prices for changes
in product attributes, particularly for products experiencing rapid
technological advances. With the growing volume of imports in tech-
nologically advanced product lines, the fact that hedonic indexes have
not been used for imported products may be imparting a significant
bias to import price indexes in certain product segments. At the same
time, adjusting prices of domestically produced products for quality
improvements has meant that price deflators in certain industries—in
particular computers and semiconductors—are rapidly falling, and, cor-
respondingly, their real value-added is rapidly increasing. As a result,
relatively small industries (in nominal terms) drive measures of real
GDP and productivity for aggregate manufacturing. One consequence
of the use of hedonic indexes has been widespread misinterpretation of
real output and productivity growth measures in U.S. manufacturing.

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 Introduction 3

In addition to examining the theoretical nature of price-index biases

that have been exacerbated by the growth of globalization, the chapters
in this volume estimate the magnitude of various biases to price indexes
and to real output and productivity growth in the United States and
other countries. The findings point to a number of significant concerns,
and the authors propose concrete solutions to address the biases, which
include changes in the way some price indexes are constructed and the
introduction of a new price survey.
The second conference volume extends the analysis to several other
measurement issues arising from the growth of globalization. The frag-
mentation of production has given rise to so-called factoryless goods
producers (FGPs): firms that design and market products but outsource
the manufacturing of their products, often overseas. Several chapters
consider the implications of a proposal to reclassify U.S. FGPs in the
manufacturing sector. The growth of global supply chains often ren-
ders traditional international trade statistics misleading. Other chapters
review new data on trade in value-added, which are designed to more
accurately depict the volume of international trade and the stages of
production performed in each country. Chapters in the second volume
also examine the classification of output of multinational corporations
in national statistics and, with the advent of the Internet, the explosion
of international trade in data.

BIASES TO PRICE INDEXES: THEORY

In “Sourcing Substitution Bias and Related Price Index Biases,”

Alice Nakamura, Erwin Diewert, John Greenlees, Leonard Nakamura,
and Marshall Reinsdorf provide a thorough examination of biases to
price indexes, with a special emphasis on biases resulting from the
growth of international trade. A set of price index biases Nakamura et
al. collectively label “sourcing substitution biases” arise from the meth-
odology the U.S. Bureau of Labor Statistics and statistical agencies in
other countries use in constructing price indexes. In particular, the BLS
collects periodic price quotes for very specific products (e.g., a 10.75-
ounce can of Campbell’s soup) sold by a specific retail outlet in the

Houseman and Mandel Vol1.indb 3 2/16/2015 8:31:37 AM

 4 Houseman

case of the Consumer Price Index (CPI), sold by a producer in the case
of the Producer Price Index (PPI), or purchased by an importer in the
case of the Import Price Index (MPI). The price changes reflected in
the CPI, PPI, MPI, and other price indexes are essentially computed as
weighted averages of the price changes of product-seller (or purchaser)
observations (e.g., the price change of a 10.75-ounce can of Campbell’s
soup sold at the Walmart outlet in Kalamazoo, Michigan) as collected
in BLS surveys.
As Nakamura et al. explain, this methodology implicitly assumes
that the “law of one price” always holds: any observed difference in
prices between apparently similar products is assumed to be the result
of differences in product quality. Yet, the law of one price is routinely
violated. Sourcing substitution bias arises when buyers shift from a high-
cost supplier to a low-cost supplier of a good or service. Because price
indexes are generally derived as weighted averages of price changes of
specific products within the surveyed establishments, price drops that
purchasers enjoy when shifting from a high- to a low-cost supplier are
not captured. The rapid growth of low-priced big-box retailers such as
Walmart and the decline of high-priced small retail stores raised con-
cerns in the past that growth of the CPI was systematically overstated
(see, for example, Reinsdorf [1993] and Diewert [1998]). So-called
outlet substitution bias is one type of sourcing substitution bias.
The dramatic growth of emerging economies, most notably China,
since 2000 and associated shifts in the location of production have raised
concerns about other types of sourcing substitution biases. The growing
share of U.S. imports coming from emerging economies reflects a shift
in production away from high-cost suppliers in the United States and
other advanced economies to low-cost suppliers in emerging econo-
mies. The cost savings enjoyed by consumers or businesses from these
shifts to low-cost overseas suppliers is not captured in the import price
index, resulting in an upward bias in this index. In addition, as empha-
sized in several chapters in this volume (Alterman; Fukao and Arai;
Houseman, Bartik, and Sturgeon; and Nakamura et al.), the import price
index is used to construct industry input price indexes, which in turn are
used to compute the growth of industry real value-added. Upward bias
to the import and input price indexes from shifts in sourcing from either
high-cost domestic or foreign suppliers to low-cost foreign suppliers

Houseman and Mandel Vol1.indb 4 2/16/2015 8:31:37 AM

 Introduction 5

results in an upward bias to aggregate and industry real GDP growth

and certain productivity measures. Nakamura et al. point out that price
index biases arising from shifts in sourcing cannot be addressed simply
by altering the formula used to construct the price indexes; the price
drop associated with the shift to a low-cost supplier is not measured
under current procedures, and no amount of reweighting of observed
prices will fix the problem.
A closely related problem for price indexes arises from the intro-
duction of new products or models, as is discussed in chapters by
Nakamura et al., Brian Kovak and Ryan Michaels, and Mina Kim and
Marshall Reinsdorf. In order to compute a price change for a specific
product sold or purchased by a specific establishment, it must be in the
sample for two periods. When new products or models are introduced
into price samples, typically it is assumed that the price change for the
new item is the same as that for closely related ongoing products—a
procedure called “linking in.” Often, however, price changes coin-
cide with model changes. For example, a company may embed a price
increase into a new model; to some degree the higher price of the new
model may reflect higher product quality and to some degree a pure
price increase. Because new models are likely to be subject to the link-
ing procedure when they are added to price samples, the price increase
in this example is missed, a problem called “product substitution bias”
(Nakamura and Steinsson 2012).
Conversely, Kim and Reinsdorf point out that, particularly for prod-
ucts undergoing rapid technical improvements, the linking in procedure
may result in a substantial overstatement of price index growth. Unlike
in other BLS price indexes, hedonic methods to adjust for changes in
product attributes, and thereby avoid linking in, are not used in the
construction of import and export price indexes. Consequently, these
indexes are especially subject to this type of bias.
Similarly, when businesses and consumers shift purchases to a
lower-cost foreign product, the product typically is not identical to the
one for which it is substituted. Indeed, the import price index, which
is based on a survey of importers, treats country of origin as a product
characteristic. This practice virtually assures that if an importer shifts its
purchases of particular products, say, from Japan to China in response
to lower Chinese prices, the Chinese products will be linked into the

Houseman and Mandel Vol1.indb 5 2/16/2015 8:31:38 AM

 6 Houseman

sample and the price drop for importers missed, no matter how close in
specification the Chinese and Japanese products.
The common justification for the assumption that the law of one
price always holds, which underlies current price index methodology, is
that arbitrage eliminates any price differences. Building on earlier work
in which they find large, systematic, and persistent cross-country price
differences among semiconductor wafers with identical product specifi-
cations (Byrne, Kovak, and Michaels 2013), Kovak and Michaels argue
that trading frictions may interfere with arbitrage. In “Assessing Price
Indexes for Markets with Trading Frictions: A Quantitative Illustra-
tion,” they develop a theoretical model describing the price dynamics
of incumbent and new suppliers when buyers face high short-term costs
in switching suppliers. Their theory is motivated by the stylized facts of
semiconductor wafer production in which it is prohibitively expensive
for wafer design firms to switch contract manufacturers for a specific
design because of high manufacturing setup costs. In the short term,
the incumbent supplier gouges firms that cannot switch. Over time, the
prices of old and new suppliers converge. Importantly, their model can
explain changes in relative prices when no change in the characteristics
of the product or service provided by the suppliers has occurred.
Several chapters examine potential sources of bias to price indexes
that are unrelated to sourcing substitution or to the introduction of new
models or products. Benjamin Bridgman examines transportation costs
for imported and exported goods and their implications for price indexes.
Usually, the lower a good’s price, the larger the share of its total price
made up by transportation or specific trade costs. Most notably, with
transportation costs generally falling over time, the price indexes of
lower-priced goods from emerging economies like China will rise more
slowly than those for higher-priced products from advanced economies,
all else being the same. Falling transportation costs, therefore, will tend
to result in an overstatement in the growth in real (quantity of) imports
from emerging economies relative to advanced economies. The size of
trade costs is particularly high in final goods prices, but Bridgman notes
that as trade costs fall, this source of bias will become less important.
As discussed in chapters by Jon Samuels, Thomas Howells, Matthew
Russell, and Erich Strassner and by Kyoji Fukao and Sonoe Arai, a
different type of bias to the input price index may arise from the fact

Houseman and Mandel Vol1.indb 6 2/16/2015 8:31:39 AM

 Introduction 7

that statistics agencies generally do not track the destination of imports

in the economy. Instead, agencies must make assumptions about how
imported goods and services are allocated between final demand and
intermediate uses in industries. Typically, statistics agencies assume an
industry’s use of an imported item is proportional to its overall use of
the input in the economy—the so-called import comparability or import
proportionality assumption. For instance, if an industry accounts for
10 percent of the use of a particular product, then it is assumed that
it uses 10 percent of the imports of that product. Input price deflators
are constructed for each industry as a weighted average of domestic
and import prices. If the allocation of imported and domestic inputs to
an industry is incorrect and if price trends of imported and domestic
inputs differ, industry input price indexes could be significantly biased.
Because input price indexes are used to compute an industry’s real
value-added and certain productivity growth measures, these statistics
could be biased as well. As Fukao and Arai note, however, if one indus-
try is using relatively more of an imported input, another industry will
be using relatively less. As a result, the biases across industries will
tend to cancel each other out and so have little effect on the accuracy of
aggregate GDP or productivity measures.

EMPIRICAL EVIDENCE OF THE EFFECTS OF

PRICE BIASES

The work in this volume significantly extends empirical research

presented at the 2009 conference on the magnitude of biases to U.S.
price index, real output, and multifactor productivity growth measures
arising from the shift in sourcing to lower-priced foreign manufactured
goods. In order to estimate these biases, researchers must make assump-
tions about the quality-adjusted price gaps for goods in advanced and
emerging economies when shifts in sourcing occur. Reinsdorf and
Yuskavage (2014) utilized apparent inconsistencies between, on the one
hand, the Consumer Price Index—which the authors point out should
be less prone to sourcing substitution bias—and, on the other hand, the
Producer and Import Price Indexes to estimate the bias to the Import
Price Index for manufactured goods. They find evidence of substantial

Houseman and Mandel Vol1.indb 7 2/16/2015 8:31:39 AM

 8 Houseman

upward biases to import price indexes in durable goods and selected

nondurable goods. Although the implication of these biases for aggre-
gate real GDP growth is modest, Reinsdorf and Yuskavage estimate that
aggregate multifactor productivity growth was overstated by about 10
percent between 1997 and 2007.
Other prior research used case study evidence along with micro-
data on import prices to assess price differences between manufactured
goods produced in emerging economies, in intermediate countries, and
in the United States and other advanced economies. Under various
assumptions about the price gap, Houseman et al. (2011) estimate that
between 1997 and 2007, real value-added in U.S. manufacturing was
overstated by 0.2 to 0.5 percentage points and multifactor productivity
by 0.1 to 0.2 percentage points. Although the bias to real value-added
growth was a relatively small share of measured growth in the computer
and electronic products industry, it may have accounted for somewhere
between a fifth and a half of the growth in the rest of manufacturing.
In this volume, authors use a variety of other evidence on price
declines associated with the shift in sourcing to low-cost foreign sup-
pliers in order to estimate biases to price indexes and to real output
and productivity growth in the United States and other countries. The
Japanese government collects unique data on the prices of products sold
in Japan as compared to other countries, including the United States
and China. In their chapter, “Biases to Manufacturing Statistics from
Offshoring,” Fukao and Arai find substantial price gaps for inputs sold
in developing countries and Japan, not only in products such as apparel
and textiles but also in machinery. They estimate that large price gaps
and growth of imported intermediates resulted in substantial underesti-
mates of real input growth and overestimates of multifactor productivity
growth, especially in Japan’s machinery sector.
In the appendix to “Measuring Manufacturing: How the Computer
and Semiconductor Industries Affect the Numbers and Perceptions,”
Timothy Bartik, Timothy Sturgeon, and I use prior estimates of the
bias to real value-added growth for U.S. manufacturing (Houseman
et al. 2011) to estimate the biases to manufacturing real value-added
growth for each U.S. state. Over the decade ending in 2007, we find
that adjusting for sourcing substitution bias lowers manufacturing real
value-added growth rates by 0.1 to 0.7 percentage points, with the larg-
est adjustments occurring in Michigan, Kentucky, Ohio, and Indiana.

Houseman and Mandel Vol1.indb 8 2/16/2015 8:31:40 AM

 Introduction 9

The biases to manufacturing examined in our chapter could result

from a shift in sourcing of intermediate inputs from high-priced domes-
tic suppliers to low-priced foreign suppliers (offshoring) or from
high-priced foreign suppliers to low-priced foreign suppliers (shifts in
import sourcing). Two chapters in the volume—“Import Sourcing Bias
in Manufacturing Productivity Growth” by Robert Inklaar and “Import
Allocation across Industries, Import Prices across Countries, and Esti-
mates of Industry Growth and Productivity” by Samuels et al.—focus
solely on the latter source of bias.
Inklaar examines what he terms “import sourcing bias” in the man-
ufacturing sector in all major trading countries from 1995 to 2008. To
estimate cross-country price differentials for specific products, Inklaar
computes unit values of imports from United Nations Comtrade data.
He acknowledges that this approach has certain drawbacks. One is that,
whereas the methodology used by statistics agencies assumes that all
cross-country price differences are attributable to product quality dif-
ferences, the use of unit values assumes the opposite extreme: None
of the observed price differences reflect product quality differences.
Moreover, because unit values are computed on fairly aggregated prod-
uct categories, there is likely to be considerable heterogeneity in the
products included in them. Despite these caveats, the average price
differentials that Inklaar finds are generally in line with case study evi-
dence, and they fall over the period studied. For the advanced European
countries, the median price differential from importing a particular
product from another advanced EU country versus a new EU country
(the latter having been former Soviet bloc members) or from another
emerging economy (such as China) was 30 to 35 percent in 1995. That
price gap had fallen to 10 percent for new EU countries and to 20 per-
cent for other emerging economies by 2008.
Inklaar estimates that annual multifactor productivity growth for
manufacturing sectors in 20 advanced countries was, on average, over-
stated by 0.18 to 0.34 percentage points, representing 13 to 25 percent
of MFP growth over the period. Evidence of import sourcing bias was
considerably higher in advanced European countries than in the United
States. Using Inklaar’s methodology, Samuels et al. also report little
import sourcing bias for U.S. manufacturing. Not surprisingly, Inklaar
finds no evidence of import sourcing bias in emerging economies.

Houseman and Mandel Vol1.indb 9 2/16/2015 8:31:41 AM

 10 Houseman

Although Inklaar’s findings should be interpreted with caution, they

suggest that import sourcing bias could be significant in many countries.
Using detailed data on prices and product characteristics for specific
items, the chapters by Kovak and Michaels and by Kim and Reinsdorf
are not subject to these concerns and also report large cross-country
differences in prices, even after carefully controlling for differences in
product quality. Kovak and Michaels use detailed proprietary transac-
tion price data between firms that specialize in the design and marketing
of semiconductor chips and foundries that specialize in fabricating chips
for these firms. They find large cross-country differences in the transac-
tion prices for chips with identical specifications, although the prices
display some convergence over time. Nonetheless, the authors acknowl-
edge that at least some part of the observed price differentials could be
the result of differences in the services provided by the fabricators, such
as the rate at which chips are rejected for quality reasons. In an industry
such as semiconductors that is characterized by high switching costs in
the short term, Kovak and Michaels argue that cross-country price dif-
ferentials observed late in the product cycle reflect time-invariant quality
differences. Adjusting for quality differences, their simulations suggest
that semiconductor price indexes substantially understate the true price
decline because price drops associated with switching to lower-cost pro-
viders in countries such as China are not captured.
In “The Impact of Globalization on Prices: A Test of Hedonic Price
Indexes for Imports,” Kim and Reinsdorf use hedonic price index
methodology to control for cross-country differences in product attri-
butes and to test for the existence of substantial biases in import price
indexes. The authors note that both rapid technological change and
shifts in sourcing across countries are likely to result in biased import
price indexes. Products from different countries or products with sub-
stantially new attributes are treated as different products, and under
the matched model procedures used in the construction of import price
indexes, price changes associated with a shift in sourcing to a lower-cost
country or with the introduction of a new product are missed. Hedonic
price indexes adjust for quality differences between products, allowing
price changes associated with the introduction of new products or shifts
in product sourcing to be taken into account. While other BLS price
indexes sometimes use hedonic adjustments to avoid these price index
biases, hedonic indexes have not been used to adjust import prices.

Houseman and Mandel Vol1.indb 10 2/16/2015 8:31:42 AM

 Introduction 11

The purpose of this chapter is to demonstrate the feasibility of hedonic

indexes for import prices, using televisions and cameras as test cases.
Kim and Reinsdorf supplement information on product characteris-
tics collected as part of the import price survey with information about
these products available on the Web. They find evidence of significant
biases in import price indexes for these product groups, both of which
were characterized by substantial technical advances and shifts in coun-
try sourcing. For televisions, they estimate an upward bias in the import
price index of 2.2 percentage points per year, of which 1.3 points derive
from undermeasured gains from new technology and 0.9 points from
unmeasured price declines from country substitution; for cameras they
estimate an upward bias of 10.5 percentage points per year, with 5.8
points deriving from technology and 4.7 points from country sourcing
changes.
The chapter by Kim and Reinsdorf underscores the importance of
accounting not only for shifts in sourcing but also for technological
change in those products when constructing price indexes. Failure to
properly account for technological improvements in imported products
could result in a significant understatement in the real growth of imports
and correspondingly in an overstatement of measures of domestic real
output and productivity growth. By implication, consistent use of
hedonic price index methodology for domestic and imported products
is critical.
The use of hedonic indexes raises other concerns, however, as is
illustrated in my chapter with Bartik and Sturgeon. The U.S. CPI and
PPI use hedonic indexes to adjust for quality improvements in prod-
ucts subject to rapid technological change, most notably computers
and semiconductors. Although adjusting for improvements in product
quality is appropriate, we argue that it has led to substantial misinter-
pretation of U.S. manufacturing statistics. In recent decades, measured
real GDP growth in U.S. manufacturing has exceeded or kept pace with
aggregate GDP, except during recessions, and many have pointed to
these growth statistics as an indicator of manufacturing’s strength in
the United States. Virtually all of that growth, however, is attributable
to the computer and semiconductor industries. Although these indus-
tries account for a small share of nominal manufacturing output, their
prices, when adjusted for product improvements, are rapidly declining,
and their real value-added growth substantially outpaces that in other

Houseman and Mandel Vol1.indb 11 2/16/2015 8:31:42 AM

 12 Houseman

industries, thus explaining the outsized effect these industries have on

aggregate manufacturing statistics. Hedonic price indexes are highly
sensitive to methodology used. Moreover, using proprietary data on
global production of computers and semiconductors, we show that the
United States was declining as a location of production for these prod-
ucts, even while they were driving the apparent robust growth in U.S.
manufacturing.
Other problems may arise from the fact that countries generally
do not track the destination of imports in the economy. The chapters
by Samuels et al. and Fukao and Arai examine possible biases to input
price indexes, real value-added, and multifactor productivity resulting
from inaccuracies in the allocation of imported inputs to final demand
and to industries as intermediate inputs. Samuels et al. find that, com-
pared to the standard import comparability assumption, allocating
imports to final and intermediate uses based on broad economic cat-
egories—as proposed by Timmer (2012)—does result in a substantially
different allocation of imports to intermediate uses for some product
categories. This alternative allocation does not incorporate any new
information about import uses in the economy but instead simply varies
the assumption about their use. In contrast, Japan collects information
on the destination of imports in the economy. Fukao and Arai exploit
this information to test how real input and multifactor productivity
growth for Japanese industries vary under import allocations based on
survey data, as compared to allocations based on the import compara-
bility assumption, which is used in most countries. They find substantial
over- and underestimates of real input and productivity growth at the
detailed industry level, although they note that, by construction, these
errors will tend to cancel each other out in the aggregate economy.
It is important to note that errors in the allocation of imports at
the industry level have potentially important implications for economic
impact analyses commonly conducted with these data. Analysts often
use industry data to predict the effects of increases or declines in an
industry’s output on employment and income at the local, regional, or
national level. These effects depend critically on industry input-output
relationships, which govern the spillover effects on employment and
income in supplier industries. The employment and income effects of
policies targeting a particular industry, for instance, will be lower as the
imported inputs used by the industry become greater.

Houseman and Mandel Vol1.indb 12 2/16/2015 8:31:43 AM

 Introduction 13

SOLUTIONS

To address biases that rapid technological progress and globaliza-

tion have likely exacerbated, several chapters propose fundamental
changes to the way various price indexes are constructed. Nakamura et
al. recommend that in many circumstances the BLS depart from its stan-
dard practice of collecting single-point-in-time price quotes for specific
products from specific establishments. They point out that the advent of
UPC codes and electronic communications enables firms to easily sup-
ply the universe of transaction prices on specific items over the course
of the month. Averaging these transaction prices within establishments
would eliminate biases to price indexes that result from sales promo-
tions. Averaging UPC transaction prices across establishments would
be necessary to address outlet substitution bias in the CPI, the form of
sourcing substitution bias that occurs when buyers shift purchases to
stores offering lower prices. Some have argued that pure transaction
price data do not reflect auxiliary attributes that products acquire as
a result of where the products are sold; for example, some consumers
may find shopping at a small but higher-priced store less time consum-
ing or otherwise more pleasant than at a low-priced big-box store. As
the authors point out, however, international guidelines explicitly state
that the unpaid time consumers take in shopping should not be taken
into consideration in constructing price indexes.
While the averaging of transaction prices for UPC codes would
help address outlet substitution bias in the CPI, it would not deal with
other types of sourcing substitution bias, including biases stemming
from shifts in purchases to low-cost foreign suppliers. This is because
no matter how similar the products, UPC codes are unique to a pro-
ducer—domestic or foreign. To address biases in import price indexes,
Kim and Reinsdorf propose using hedonic indexes in lieu of matched
model indexes, which miss price changes that occur whenever new
models are introduced or importers shift to lower-cost foreign suppli-
ers. The authors demonstrate that information already collected as part
of the BLS import prices program, when supplemented with publicly
available information on the Internet, is sufficient to implement hedonic
indexes, and that biases in matched model indexes can be sizable.

Houseman and Mandel Vol1.indb 13 2/16/2015 8:31:44 AM

 14 Houseman

The use of hedonic indexes in computing import price indexes

would only address sourcing substitution biases associated with shifts
from a high- to a low-cost foreign supplier. To more completely address
sourcing substitution bias in input price indexes, William Alterman, the
former BLS assistant commissioner for international prices, proposes a
new price index that would be based on a survey of input purchasers. As
noted, input price indexes miss price declines whenever firms shift from
high- to low-cost suppliers of intermediate inputs; these shifts could be
from a high- to a low-cost domestic supplier, from a high-cost domes-
tic supplier to a low-cost foreign supplier, or from a high-cost foreign
supplier to a low-cost foreign supplier. When such price drops are not
captured, the growth of the industry’s input price index, real value-
added, and certain productivity measures are overstated. In theory,
input purchasers could report a price change, even when they source
the input from a new supplier. In “Producing an Input Price Index,”
Alterman reports findings from an initial examination of the feasibility
of constructing an input price index for materials inputs. Although some
technical issues along with budget constraints pose significant chal-
lenges to the introduction of a new price survey, Alterman concludes
that fielding a sample of materials purchasers is possible and that, in
general, businesses can periodically report prices on input purchases.
Nakamura et al. and Kim and Reinsdorf point out that, if implemented,
such a survey would need to collect data on product characteristics so
that prices could be adjusted for changes in product attributes whenever
models or suppliers change.
Alterman acknowledges that the proposed input price bias is not a
panacea. It would not, for instance, capture price declines when firms
outsource or offshore work previously done in-house. This is because
data on the price for work previously done in-house would not exist and
so could not be compared to the price from an arm’s-length transaction.
Moreover, because in official statistics aggregate GDP is computed
from the expenditure side as the sum of final consumption, investment,
government purchases, and net exports—not as the sum of value-added
across industries—a fully implemented input price index would address
biases from sourcing substitution to real GDP and productivity mea-
sures for industries, but not for the aggregate economy. The use of
hedonic indexes for import prices, as proposed by Kim and Reinsdorf,

Houseman and Mandel Vol1.indb 14 2/16/2015 8:31:44 AM

 Introduction 15

would address some of the bias to both aggregate and industry real GDP
measures from sourcing substitution. Information from biases to the
input price index or from discrepancies between movements in the CPI,
PPI, and MPI, as discussed in Reinsdorf and Yuskavage, potentially
could be used to better address biases to aggregate output and produc-
tivity measures.
Adjusting prices for changes in product quality, however, also
may mean that products experiencing rapid technological change will
dominate movements in aggregate statistics, as Bartik, Sturgeon, and I
illustrate with the outsized effect that the computer and semiconductor
industries have on real GDP growth in U.S. manufacturing. To mitigate
confusion and misinterpretation of the data, we argue that statistical
agencies should make clear the influence certain industries have on
aggregate statistics—for example, by also publishing subaggregates
without these industries.
The case of U.S. manufacturing raises broader questions about how
to measure competitiveness in a global economy and in an era of rapid
technological change. Traditionally, economists and policymakers have
looked to real output and productivity measures to assess an industry’s
competitiveness. Yet the United States was declining as a location for
production of computers and semiconductors even while these indus-
tries accounted for the robust output and productivity growth in U.S.
manufacturing. My coauthors and I argue that international data on the
location of production are necessary to assess the global competitive-
ness of a particular industry or sector in a country.
In addition, the fragmentation of production raises difficult classifi-
cation issues. For example, although the competitiveness of the United
States as a location for the production of computers and semiconductors
has declined, much of the product design work and marketing remains
in the United States. These activities usually are counted in the research
or wholesale trade sectors, though they traditionally are integral parts of
manufacturing. These developments arguably necessitate a rethinking
about how activities in the economy are classified.
The companion to this volume examines these issues in greater
depth. Several chapters focus on a recent proposal to classify so-called
factoryless goods producers in manufacturing, explaining the rationale
for the proposal, the current prevalence of FGP activities in the United

Houseman and Mandel Vol1.indb 15 2/16/2015 8:31:45 AM

 16 Houseman

States, and the likely effect of such a change in classification on manu-

facturing statistics. The second volume also reports on recent efforts
to develop data sets measuring trade in value-added. Value-added of
a product produced in a global supply chain may be counted multiple
times in international trade statistics, which measure gross flows of
imports and exports. Electronic components, for example, produced in
Japan may be exported to China for assembly into final consumer goods.
The value-added of the electronic components will be counted once in
Japan’s exports and again in the Chinese exports of consumer electron-
ics. Similarly, bilateral trade statistics can be misleading: Imports from
a particular country may contain substantial amounts of value-added
from other countries, and the import content of a country’s exports may
be sizable. Data on trade in value-added are needed to understand what
is made where and, ultimately, to assess the competitiveness of national
industries and activities in the supply chain. Advances in technology
and communications that have allowed the explosion of trade in manu-
factured products have permitted the rapid expansion of multinational
companies and of trade in services and intangibles, many of which were
previously regarded as “untradeable.” Chapters in the second volume
also examine the thorny issue of attributing output from multinational
companies to the countries in which they operate as well as evidence
that trade statistics greatly understate cross-border flows of data, raising
concerns about recent policies in some countries to discourage these
flows.

Note

1. The conference “Measurement Issues Arising from the Growth of Globalization”

was held November 6–7, 2009. Summaries of the conference research and of its
research papers are available at http://research.upjohn.org/externalpapers/7/ and
http://research.upjohn.org/reports/130/, respectively.

Houseman and Mandel Vol1.indb 16 2/16/2015 8:31:46 AM

 Introduction 17

References

Byrne, David, Brian K. Kovak, and Ryan Michaels. 2013. “Price and Qual-
ity Dispersion in an Offshoring Market: Evidence from Semiconductor
Production Services.” NBER Working Paper No. 19637. Cambridge, MA:
National Bureau of Economic Research.
Diewert, W. Erwin. 1998. “Index Number Issues in the Consumer Price Index.”
Journal of Economic Perspectives 12(1): 47–58.
Houseman, Susan, Christopher Kurz, Paul Lengermann, and Benjamin R.
Mandel. 2011. “Offshoring Bias in U.S. Manufacturing.” Journal of Eco-
nomic Perspectives 25(2): 111–132.
Nakamura, Emi, and Jón Steinsson. 2012. “Lost in Transit: Product Replace-
ment Bias and Pricing to Market.” American Economic Review 102(7):
3277–3316. http://pubs.aeaweb.org/doi/pdfplus/10.1257/aer.102.7.3277
(accessed April 3, 2014).
Reinsdorf, Marshall B. 1993. “The Effect of Outlet Price Differentials on
the U.S. Consumer Price Index.” In Price Measurements and Their Uses,
Murray F. Foss, Marilyn E. Manser, and Allan H. Young, eds. NBER Stud-
ies in Income and Wealth 57. Chicago: University of Chicago Press, pp.
227–254.
Reinsdorf, Marshall B., and Robert Yuskavage. 2014. “Effects of Offshoring
and Country Substitution on Measurement of Prices and Productivity.”
Working paper. Washington, DC: Bureau of Economic Analysis.
Timmer, Marcel, ed. 2012. “The World Input-Output Database (WIOD): Con-
tents, Sources, and Methods.” WIOD Working Paper No. 10. Brussels:
European Commission.

Houseman and Mandel Vol1.indb 17 2/16/2015 8:31:47 AM

Houseman and Mandel Vol1.indb 18 2/16/2015 8:31:47 AM
 Part 1

Trade-Related Biases to
Price Indexes: Theory

Houseman and Mandel Vol1.indb 19 2/16/2015 8:31:48 AM

Houseman and Mandel Vol1.indb 20 2/16/2015 8:31:49 AM
 2
Sourcing Substitution and
Related Price Index Biases
Alice O. Nakamura
University of Alberta

W. Erwin Diewert
University of British Columbia and
University of New South Wales

John S. Greenlees
formerly of the Bureau of Labor Statistics

Leonard I. Nakamura
Federal Reserve Bank of Philadelphia

Marshall B. Reinsdorf
International Monetary Fund

Price indexes are fundamentally important for understanding what

is happening to national economies. Unfortunately, for reasons we will
explain, price-index bias problems seem likely to have grown with the
evolution of information technologies and accompanying changes in
business price setting and product-variant development practices, as
well as with the growth in the amount and timeliness of price infor-
mation available to potential buyers. We argue, however, that specific
changes to statistical agency practices and data-handling capabilities
can greatly reduce the bias problems we focus on.
We recommend hybrid alternatives to the conventional price
indexes. Our hybrid indexes use unit values to combine price infor-
mation for transactions that take place at different prices for homo-
genous product items. The hybrid indexes reduce to the conventional
price indexes when there is truly just one price per product each time

21

Houseman and Mandel Vol1.indb 21 2/16/2015 8:31:49 AM

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