Eementary aggregate indices and lower level substitution bias

Abstract

Elementary aggregates (EAs) represent the lowest level at which price indices are constructed and are the first step in calculating an index of the general level of prices. There is currently debate regarding the appropriate index formula to employ in elementary aggregates. The choice between two of these, the Jevons (a geometric mean of price ratios) and the Carli (an arithmetic mean of price ratios) indices is often characterised as being determined by whether or not consumers substitute between products as relative prices change. Under certain assumptions a Jevons may be appropriate where there is substitution behaviour whilst a Carli may be appropriate where there is none.

We estimate the elasticity of substitution using econometric and algebraic techniques suggested elsewhere in the literature and also propose an extension to the algebraic technique. We employ sub-sampling techniques to overcome obstacles faced when applying these methods to panel data on alcohol consumption. We find that estimates of substitution behaviour are insufficient for informing the choice of index formula at the EA level, which in part may be due to the presence of demand side effects that are not accounted for.