Real versus nominal, constant price versus current price: A comment on some terminology that is used in economic statistics

In a recent critique of this paper by Dr Andrew Leigh and Dr Chris Ryan, Dr David Zyngier has suggested that a time series on education expenditure that is constructed by Leigh and Ryan is wrong. One of Zyngier's reasons for making this claim is his belief that Leigh and Ryan (2008) did not adjust for inflation. While it is true that Leigh and Ryan did not adjust the education expenditure data in Appendix Table 2 of their paper to account for inflation, they did not claim to do so. Indeed, the title of that table is "Nominal education expenditure (Spending per child per year, in current dollars)". Zyngier appears to have confused nominal data with real data. Specifically, he has interpreted "current dollars" to mean "constant 2003-2004 dollars". I suspect that this confusion may have been caused by a lack of familiarity with the terminology of economic statistics on the part of Zyngier. While Leigh and Ryan (2008) are correct to use the term "current dollars" to refer to nominal data, it is not difficult to see why someone who is unfamilar with the terminology employed in economic statistics might misinterpret this to mean "constant prices for this year" or maybe "constant prices for the most recent year in the data set". Such a mistake is understandable. After all, the everyday meaning of "current" is "now", not each of many previous points in time. Nonetheless, while such a mistake is understandable, it still renders this aspect of Zyngier's criticism of Leigh and Ryan (2008) invalid.

In economic statistics, current dollar figures refer to nominal values. These are valued in terms of the dollars of the year in which the expenditure took place. On the other hand, constant dollar figures refer to real values. These are valued in terms of a particular years dollars. I suspect that misinterpreting "current dollars" to mean "constant dollars of the the most recent year in the time series" is probably an easy and understandable mistake to make for people who are not familar with the terminology employed in economic statistics.

The distinction between nominal (or current price) data and real (or constant price) data exists because time series data on pure quantities is sometimes unavailable in circumstances where time series data on expenditure and time series data on prices is available. In these circumstances, it is possible to obtain an index that represents the implicit time series data on quantities by:

1. Constructing an expenditure index from the nominal expenditure time series;

2. Constructing a price index from the price time series; and

3. Deflating (that is, dividing) the nominal expenditure index by the price index.

4. Renormalising the resulting quantity index so that it has a base year.

The result of this is an index of the underlying quantities. If the time series of nominal expenditure itself is deflated by the price index, then the resulting data will be a time series of real expenditure. This is simply actual expenditure valued at the prices that prevailed in whatever year is chosen as the base year.

When it comes to actual data, things are, of course, much more complicated. In particular, it is necessary to deal with both aggregation and quality changes when constructing the underlying price index. There are also other techniques for constructing volume (or quantity) indices, including the use of chain weights. There is a large literature on the properties of various different types of indices. An overview of this literature can be found at this website for a course on index numbers that is taught by Professor Erwin Diewert at the University of British Columbia in Canada.

Note 1. The full reference for Leigh and Ryan (2008) is: Leigh, A and C Ryan (2008), "How has school productivity changed in Australia?", mimeo The Australian National University, Canberra.

Note 2. Dr Zyngier's criticisms of Leigh and Ryan (2008) appear in three places. The first place they appear is in this article in the online version of the Australian's Higher Education Supplement from Wednesday 19 March 2008. The second place they appear is in a letter to the editor of the online version of the Age from Tuesday 1 April 2008. However, it should be noted that this letter does not explicitly mention the current doolar versus constant dollar issue. The third place in which it appears is in this comment on this post at Dr Leigh's blog site. Andrew addresses a different aspect of Dr Zyngier's critiques in the post mentioned above.

Note 3. While Leigh and Ryan (2008) privide a time series of nominal education expenditure in their Appendix Table 2, they also provide three alternative time series of real education expenditures in their Appendix Table 4. The real data is presumably based on the nominal expenditure data in their Appendix Table 2 and three alterenative price indices that are provided in their Appendix Table 3.

Update: I have made some edits to this post, including the addition of point four in the section of the post that discusses the construction of a quantity index from a time series on nominal expenditures and a time series on prices.

Ten years of the Productivity Commission

The Productivity Commission celebrates the tenth anniversary of its formation this year. It was formed through the amalgamation of three predecessor bodies. These were the Industry Commission, the Bureau of Industry Economics and the Economic Planning Advisory Council. It is worth noting that the Industry Commission itself was formed from the former Industries Assistance Commission, which had earlier been formed from the former Tariff Board.

The Productivity Commission and its predecessor bodies have made many important contributions to the research and analysis of microeconomic issues facing the Australian economy. A nice discussion of the quantitative techniques used in some of the microeconomic research conducted by the Productivity Commission can be found in the following paper by Dr Philippa Dee, a former head of the Productivity Commission's Trade and Economic Studies Branch:

Dee, P (2005), Quantitative modelling at the Productivity Commission, Productivity Commission Consultancy Paper, Productivity Commission, Melbourne.

This paper is available online at this part of the Productivity Commission's website.

Disclosure: I have previously worked for the Productivity Commission on two separate occassions.

Update: As a further disclosure, I should probably note that during one of the occassions that I worked at the Productivity Commission, I was located in the Trade and Economic Studies branch while Dr Philippa Dee was the head of that branch.

Editorial policy

Please note that I reserve the right to edit blog posts after they have been published on this blog. Furthermore, I reserve the right to delete blog posts after they have been published on this blog. In the event that such edits or deletions are made, I am not obliged to indicate this. Finally note that this policy applies retrospectively. Indeed, it has already been applied retrospectively. Earlier today, I deleted two blog posts and made a minor edit to one other post. The minor edit consisted of adding a single word ("tell") to the end of a sentence ("Only time will tell") in the first post on this new version of my blog ("A new beginning").

What economics means to me

The following is a short essay on "what economics means to me". It has previously appeared on the original version of this blog and in the series of short essays about "What economics means to me" on the website of the Department of Economics at the University of Texas at Austin.

Short essay

"I am an economist by trade, training and choice. Economics is both a career and a hobby to me. In this short essay, I briefly set out some of my thoughts on the nature of economics, where it has come from and where it is going. Economics is a social science. Like other social scientists, economists attempt to understand the forces that shape the behavior of individuals, the formation of institutions and the structure of societies. The factor that differentiates economics from the other social sciences is a focus on scarcity. If scarcity is present, and it almost always is, then economic analysis is likely to shine some light on the phenomenon being considered. Scarcity forces trade-offs. As the saying goes, there is no such thing as a free lunch!

Economics began as a distinct discipline with the publication of Adam Smith's An inquiry into the nature and causes of the wealth of nations in 1776. This publication introduced the concept of the invisible hand, referring to the process by which the interaction of agents in unimpeded markets resulted in an improvement in social welfare. The logic underlying this result is incredibly simple. If two people choose to trade with each other, then both of them must be better off. After all, if this were not the case, then the agents would not agree to trade in the first place. Despite the simplicity of this idea, it took the best part of two centuries for economists to formally establish the conditions under which this result is true. During that time, the primary focus of economics was on the operation of markets in a competitive setting and the properties of the resulting allocation of resources. This work culminated in the establishment of the existence and welfare properties of a general competitive equilibrium. These results are incredibly important because they provide a benchmark model of the operation of an economic system. This benchmark model establishes the conditions under which Adam Smith's invisible hand actually works. It also provides a starting point for the analysis of what happens when these conditions are violated.

While the general competitive equilibrium model of an economy provides an important benchmark, it leaves many of the most interesting questions unanswered. In particular, it does not provide an explanation for the existence of many economic and social institutions. These include families, firms, clubs, retailers, unions, governments, money and even markets themselves. Furthermore, the general competitive equilibrium model of an economic system does not provide an analysis of the nature of competition when economic agents are neither so small that they have no influence on the markets in which they participate nor so big that they completely dominate the markets in which they participate. Nor does it provide an analysis of the process of price formation. An analysis of the existence and operation of institutions, the nature of competition and the process of price formation all require the use of game theoretic techniques. Many of these techniques have only recently been developed to a point at which they can begin to be used in analysing these phenomena. The potential for game theoretic techniques to shed light on some of these important aspects of societies that we do not yet completely understand ensures that it is an exciting time to be an economist."

The subject matter of economics

My favourite definition of economics is the following one:

"--- economics is the science which studies how scarce resources are employed for the satisfaction of the needs of men living in society: on the one hand, it is interested in the essential operations of production, distribution and consumption of goods, and on the other hand, in the institutions and activities whose object it is to facilitate these operations." (Italics in original.)

This definition comes from page 1 of Malinvaude, E. (1972), Lectures on microeconomic theory, Advanced Textbooks in Economics Volume 2, North Holland Publishing Company, Scotland(translated by Mrs. A. Silvey).

One reason that I like this definition is that, in addition to emphasising the importance of scarcity, it actually goes on to discuss the types of questions that are addressed by economists. In particular, I like the fact that it mentions institutions.

As I see it, the key components of the subject matter of economics are:

1. The presence of scarcity;

2. The behaviour of individuals who are faced with scarcity;

3. The interaction of individuals who are faced with scarcity; and

4. The existence and operation of institutions to facilitate the interaction of individuals who are faced with scarcity.

Note that the presence of scarcity is the central defining feature of the subject matter of economics. In the absence of scarcity, economics would not exist. There would be no need for it!!!

A new beginning

This is a new version of this blog. I originally started this blog a while back, but I deleted it after I decided to stop blogging, at least for a while. I briefly restarted it a short while ago, but deleted it very shortly after setting it up again. I have decided to start the blog up once again. However, I might not post very often. Indeed, I might not make any further posts at all. Only time will tell. Furthermore, I will not be allowing comments on any posts on this blog, at least for now.