Measuring the Welfare Effect of Quality Change: Theory and Application of Japanese Autos

The purpose of this paper is to identify conditions under which hedonic price indexes provide an exact measure of consumer welfare, so that the welfare effects of quality change can be inferred. Our results are quite positive in providing a rational for existing practices, though the conditions needed to justify these practices are somewhat restrictive. An application of our results is provided to the increase in characteristics of Japanese autos sold in the United States following the imposition of quotas in 1981. We argue that consumers did not value the additional characteristics at their former shadow-values, but rather, attached a lower value to the increase in characteristics. We compute the exact index that reflects this lower imputed value, and compare it to the conventional quality adjustment. The deadweight loss associated with the quality change is between one-quarter and one-third of the value of upgrading.