Calculating Hedonic Price Indices with Unobserved Product Attributes: An Application to the UK Car Market

We show that hedonic price indices that omit model‐specific unobservable product attributes are subject to considerable bias. We utilize a complete panel of new car versions marketed in the UK over 1971–98 which incorporates over 100 observable product characteristics, sales weighting to capture the distribution of purchases across models, and model‐specific fixed effects to account for unobservable characteristics. We find that quality‐adjusted prices obtained from hedonic regressions that do not account for unobservable characteristics exhibit a severe downward bias. We also show that quality‐adjusted prices exhibit distinct sub‐market differences having increased in ‘mass production’ segments and decreased in ‘specialized niches’.