Measuring the Substitution Effect in Producer Price Index Goods Data: 2002-2016

Jonathan Weinhagen

Abstract

The Bureau of Labor Statistics calculates the US Producer Price Index using a modified Laspeyres formula that employs fixed quantities as weights but allows prices to vary over time. Having fixed quantities as weights imposes a restriction on substitution in response to relative price change. This paper examines the effects of the substitution restriction by re-estimating select Final Demand-Intermediate Demand (FD-ID) PPIs from 2002 through 2016 on an annual basis using fixed-based Fisher and Tornqvist formulas, both of which allow for substitution. These experimental FD-ID indexes are calculated from annual average values of commodity indexes with weights updated annually. Subsequently, the experimental indexes are compared to the same indexes calculated using the fixed-based Laspeyres formula. The paper will demonstrate that, in general, the experimental FD-ID indexes calculated using formulas that allow for substitution result in lower in index values than those calculated using the Laspeyres formula, implying substitution toward relatively less expensive products.