Information Costs and Hedonics

by Gary North

Recently by Gary North: Moving How Far Out?

We are living in the greatest era of falling prices in the history of man. Our lives are being transformed by this phenomenon year by year, yet most of us take the change for granted. We barely notice it. Yet we would wonder what is wrong if it ceased.

Falling prices, you say? What falling prices? Where is there any sign of this.

Right in front of your eyes. Literally.

You are probably reading this on a computer screen. It is full color. It is thin and lightweight. It is probably 17 inches – maybe larger. If it wears out (which it won't for years), you will replace it for a monitor that costs less than you paid for this one.

What would you have paid for it five years ago? What would you have paid for it a decade ago? Nothing like it was available ten years ago.

Earlier this week, I wrote a brief article that included a series of funny YouTube videos ridiculing taxes. One was British. One was Canadian. One was American. It took me about five minutes to write that article and embed the videos on a page. I posted the page on my site by clicking a button. Anyone on earth who follows my posts can read that page. He can click each video and enjoy the fun. See for yourself.

How could I have done this six years ago? YouTube did not exist six years ago. You can verify this on Wikipedia, which did not exist eleven years ago.

Are you getting my drift? That which we take for granted today is revolutionary. Much of it did not exist during the dot-com bubble. It appeared after that Federal Reserve-created bubble had popped.

WIKIPEDIA AS THE MODEL

You can consult an encyclopedia with 17 million free articles. Here is a list of the languages available.

Only 3.5 million are in English, but there is translation software a click away that will translate most of the others into readable English with one mouse click. They are then readable.

It is not just that the intellectual division of labor keeps these entries updated and corrected. It is this: nothing can stop you from consulting them. The governments of the world might like to stop some of them from being posted, but they cannot do this. In any case, there are too many online articles to evaluate. Government bureaucrats cannot keep pace with the rate of change.

How do we compare Wiki and its many imitators with what was available in 2000? Nothing like them existed in 2000. They are all free. We cannot compare the "Encyclopedia Britannica" with Wikipedia. I bought a digital version of Britannica a few years ago. I used it only once. I shall not use it again. A few thousand articles written by lone scholars are not worth paying for. There has been a quantum leap in the production of encyclopedia articles. That which is free has completely replaced that which has a price tag.

You want price deflation? You've got it.

How can we measure this? Whatever a standard encyclopedia on a disk was in 2000, Wikipedia is orders of magnitude greater today. We would need a log-scale graph to compare their content. Yet Wiki is free. That is price deflation of 100%.

DEVISING A PRICE INDEX

Let's say that you were hired by the Bureau of Labor Statistics to compare encyclopedias at the end of 2000 with those at the end of 2010. You are asked to calculate the cost of information. You go to the Encyclopedia Britannica in 2000. There were about 15,000 articles. Do you calculate cost per article? Go ahead. Put 15,000 as the denominator. Do you calculate Wikipedia's cost per article with a denominator of 3.5 million or 17 million? Remember, there is translation software that did not exist in 2000. Is a translated article worth (say) 70% of an English language article? Or maybe only three-fifths? It does not really matter. The numerator is zero.

It will be zero next year and the year after. Then what? How should you calculate the price effects of (say) 7 million English-language articles with 3.5 million, when they all cost zero? This is not a trick question. It is a real-world question.

If the numerator is zero today, and it will be zero in ten years, but the supply doubles, is that relevant? Of course it's relevant. You get twice as much for free. I reply that the price has not fallen. It is still zero.

"But," you reply, "we have to do something with that doubled supply. We can't just pretend there has been no change. More is better than less, right?"

So, you propose a modification of the formula. You insist that there has to be an implicit price adjustment based on doubled output. The price per article remains the same – zero – but there has to be an implicit reduction of price. Otherwise, the public will be misled. People will think that things have not gotten better, when in fact things are twice as good. Well, not really twice as good. The next 3.5 million articles will be on less important topics. There is a declining rate of return. Economists say that the marginal value of each additional article falls.

Now what should you do? Things are obviously better by 3.5 million articles. But how can we estimate how much better? There is no theoretically valid answer. We cannot come up with a formula that estimates the collective value of those extra 3.5 million English-language articles. We cannot scientifically measure the subjective valuation of any reader, let alone all readers. That newly posted article on your brilliant career may not be worth much to the rest of us, but you will surely be ecstatic – if it's nice. You will be outraged if it isn't. How do we measure the marginal value of that article? We can't.

Yet we have to say something relevant. After all, 7 million articles are better than 3.5 million. We just do not know how much better.

So, you will have to fake it. You have to do something that reflects the newer, better state of affairs. Even if you use some simplistic formula – "articles cost half as much apiece" – meaning half of zero, this still conveys a more accurate picture than if you say that nothing has changed: zero is still zero.

Do you agree so far?

HEDONICS

There is such a formula. The Bureau of Labor Statistics applies it. The rest of us really don't know how it works. Face it: we don't know much about how anything works.

The important thing is this: the formula does not change. We can see the trend, even though we cannot be sure if the formula is accurate. The fact is, no formula is accurate. But a formula that acknowledges that 7 million at zero price is better than 3.5 million at zero price is better than a formula that doesn't.

A hedonics formula says that improvements in quality count for something. Yes, we can always reply: "Count for how much?" The statistician replies, "I don't really know, but something." He is correct. If there is no implicit deflationary formula that reflects the fact that we are getting more than before at zero monetary price, then we cannot begin to understand economic history.

BETTER AND BETTER

In a free market economy, there is constant competitive pressure to improve quality. The history of the free market social order is a story of small improvements in most things offered for sale, interspersed with major improvements that change everything. Think of electricity, automobiles, medical care (Salk vaccine for polio), and on and on. Our world today would be barely recognizable to a person transported through time from 1900. Similarly, the world of 1900 would not be recognizable to someone living in 1800.

Late last year, I interviewed the grandson of President John Tyler. I would also like to interview his brother. John Tyler was born in 1790. Think of his world at age 20 compared to our world at age 20. The economic world of Jesus at age 20 would have been more recognizable to John Tyler than our world.

Because of the fractional reserve banking system, our world is constantly dealing with rising prices. Because of rising prices due to monetary inflation, this increased physical output due to capital investment and innovation is concealed. This element of concealment is more than mere increases in physical output. It is also due to improved quality.

I used the example of Wikipedia, because it is so spectacular. Also, we can compare the number of articles with conventional commercial encyclopedias. I found that the Wiki articles are far better than the articles on Microsoft's Encarta. So did everyone else. Microsoft abandoned Encarta in 2009. It had 62,000 articles when it finally was killed. How do I know this? I read about it on Wikipedia.

CRITICS OF HEDONICS

What astounds me is this: there are journalists out there who insist that the hedonics implicit deflator is some kind of scam by the Bureau of Labor Statistics. This is another way of saying that the increased output of free market social order should be ignored. The critic is saying this: "If we cannot see a price change, no change happened." Or, put another way, going from no entries on Wikipedia in 2000 to 17 million in 2011 did not lower the cost of information in the United States. After all, free is free. The numerator did not change.

Maybe you think I am exaggerating. Maybe you think that nobody could be this dense intellectually. You would be wrong. You do not factor in what I like to call the Brett Arends school of financial reporting. Mr. Arends writes for the Wall Street Journal. In an article posted on January 26, he wrote this.

Or consider the case of Apple computers. We all know Macs are expensive. And we know Apple doesn't discount. The cheapest Mac laptop today costs $999. A few years ago, it also cost $999. So the price is the same, right?

Ha. Not according Uncle Sam. Using a piece of chicanery called "hedonics," Uncle Sam calls this a price cut. His reasoning? You're getting more for the money. Today's $999 Mac is lighter, fancier and faster than last year's $999 Mac. So the government calculates that the "real" price has actually fallen.

How's that work in the real world? Try it. Go into your local Apple store and ask for 50% off thanks to hedonics. (If you do, please, please video the exchange and put in YouTube. We could all use a good laugh.)

Instead, the government is worrying about deflation, partly because of all the "cheap" MacBooks out there.

Mr. Arends' version of rhetoric is to ask us to try to get a discount Mac – today's Mac – based on hedonics. But you can surely get a discount on a 2005 Mac. My daughter will sell you hers for only $800. And if you are dumb enough to pay that much, I will put your story on YouTube, as he suggested.

Here is my challenge to Mr. Arends. I challenge him to find a YouTube video posted in January 2005 describing the 2005 Mac.

Problem: there was no YouTube in January 2005. The site did not exist.

But, in the world of Brett Arends, YouTube would not be in the hedonics formula. After all, YouTube is free today. It was free in January 2005, since it did not exist. Conclusion: there has been no economic change. After all, zero is zero. Right? We should compare numerators with numerators. Forget about denominators: the products. They are irrelevant. Price is all that matters: numerators.

He went on.

The second reason to treat the official inflation figures with some mistrust is that they look backward. They register what just happened, not what's about to happen next.

OK, so the prices of many things haven't risen. Yet. But if the laws of economics mean anything, they will have to. Why? Because costs are rising.

Consumer prices are set by consumers competing against each other in a huge auction process. Producers compete against producers. The outcome is an array of prices. If the prices of raw materials are rising, this is because buyers are forecasting increased demand by future consumers – demand that it will be profitable to meet. So, manufacturers bid against each other, while raw materials sellers compete against each other.

The marginalist revolution explained rising materials cost in terms of expectations by manufacturers. Rising costs do not lead to rising prices. Rising costs are the outcome of an auction process that is based on the expectation of rising demand. Arends has causation backwards.

In any case, it is not the job of the Bureau of Labor Statistics to register future consumer prices, factoring in rising raw materials production prices into the Consumer Price Index, which measures changes in – memo to Arends – CONSUMER prices.

He goes on:

Sooner or later this is going to show up in your supermarket, or at the mall, in higher prices.

Really? What if there is a double-dip recession? What if there is a contraction in Chinese consumers' demand for goods because of the phenomena described by the Austrian theory of the business cycle: monetary inflation followed by monetary stabilization? What if the forecasts are wrong? Then consumer prices will fall, and raw materials factors also will fall.

Rising raw materials prices may be a good forecasting tool some of the time, because entrepreneurs who are paid to forecast prices have bid up raw materials prices. But – another memo to Arends – the price of food is not subject to the BLS hedonics formula. The BLS does not assume that there are significant improvements in food quality that justify implementing the hedonics formula in this sector of the economy.

He has moved without telling the reader from the realm of digits – Mac computers – to the realm of raw materials. To put it simply, he has criticized the hedonics formula, which applies to "electrons," as if it applied to "atoms": food. He has dismissed the hedonics formula, calling it "chicanery." He is inescapably also calling into question the real-world effects of constant attention to quality that the free market encourages through the system of profit and loss.

I remind him and anyone else who follows his line of reasoning: "You can't beat something with nothing." If the BLS formula is chicanery, then which formula isn't? Show that this rival formula enables us to better understand the extraordinary improvements in quality and the historically unprecedented decline in costs in the realm of computers and digital communications.

My advice: forget about the weakness of the formula. Pay attention to the trend. In matters digital, the trend is down. With respect to the cost of information, the trend is down.

CONCLUSION

To get some idea of what Mr. Arends is ignoring, read my article on Moore's law and the other parallel laws that are transforming our world. Output in the realm of silicon and fiber optics is now doubling every 12 to 24 months in two dozen fields. This is transforming our world as never before.

Let's hear it for hedonics! More free Wiki articles, more free YouTube videos, more free LewRockwell.com articles, more free books in Mises.org's Literature section. At zero price, I want more, more, more. I am not insatiable – my time has value – but I want lots of producers trying to meet my demand. Give it a shot, guys! See if I overload.

February 4, 2011

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North

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