<p>No this does not create distortions. It is actually a correction for distortions created by inflation.</p>
<p>If firm’s <span class="math-container">$i$</span> price increases but industry prices remain same this indicates that firm <span class="math-container">$i$</span> is producing more valuable product so even if quantity of output remains constant you can consider this improvement in firm <span class="math-container">$i$</span> productivity as it can produce more value per units of input.</p>
<p>But if all prices in the industry increase this will likely be due to inflation (drop in value of money). You would typically want to control for this and convenient way is to deflate nominal values.</p>

CC BY-SA 4.0
2021-11-16T12:47:27.000Z
Yes, that makes a lot of sense, thanks for your answer!
futur3boy
CC BY-SA 4.0
2021-11-16T12:18:06.030Z
2021-11-16T12:18:06.030Z
1muflon1
<p>When measuring TFP with the Olley-Pakes method for example, why is it the case that the input and output prices are deflated by an industry price index? What's the intuition behind this?</p>
<p>Say we use the following equation do calculate the TFP measure, where output is produced with a standard cobb-douglas production function and equation 2 is in logs, then why do most or all papers deflate the prices, doesn't this distort our output measure when we &quot;modify&quot; the prices? What's the intuition behind this?</p>
<p><span class="math-container">$1: sales = price \cdot output $</span></p>
<p><span class="math-container">$2: sales = (p_{jt} - \bar{p_{jt}}) + productivity_{j} + αl_{jt} + βk_{jt} + u_{jt}$</span></p>

<productivity><deflation>
Why are prices deflated in a productivity estimation?
futur3boy
# Why are prices deflated in a productivity estimation?

(Asked by: username_0 on 2021-11-16)

When measuring TFP with the Olley-Pakes method for example, why is it the case that the input and output prices are deflated by an industry price index? What's the intuition behind this?

Say we use the following equation do calculate the TFP measure, where output is produced with a standard cobb-douglas production function and equation 2 is in logs, then why do most or all papers deflate the prices, doesn't this distort our output measure when we "modify" the prices? What's the intuition behind this?

$1: sales = price \cdot output $

$2: sales = (p\_{jt} - \bar{p\_{jt}}) + productivity\_{j} + αl\_{jt} + βk\_{jt} + u\_{jt}$

**Tags:** productivity, deflation


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## 1 answers

### Answer by username_1 on 2021-11-16. Score: 0 | Accepted answer

No this does not create distortions. It is actually a correction for distortions created by inflation.

If firm’s $i$ price increases but industry prices remain same this indicates that firm $i$ is producing more valuable product so even if quantity of output remains constant you can consider this improvement in firm $i$ productivity as it can produce more value per units of input.

But if all prices in the industry increase this will likely be due to inflation (drop in value of money). You would typically want to control for this and convenient way is to deflate nominal values.

> **Comments:**
> **username_0**: Yes, that makes a lot of sense, thanks for your answer!  

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