What is hedonic pricing?
Hedonic pricing is a model that identifies price factors based on the premise that price is determined by both the internal characteristics of the good sold and the external factors that affect it. A hedonic pricing model is often used to estimate the quantitative values of environmental or ecosystem services that directly affect house market prices. This evaluation method may require a high degree of statistical expertise and model specification, after a period of data collection.
Key points to remember
- Hedonic pricing identifies the factors and characteristics that affect the price of an item.
- Hedonic pricing is most often seen in the housing market, where the price of a property is determined by the characteristics of the property itself.
- Hedonic pricing only reflects a consumer’s willingness to pay for what they perceive to be environmental differences.
Understanding hedonic pricing
The most common example of the hedonic pricing method is found in the housing market, where the price of a building or land is determined by the characteristics of the property itself (for example, its size, its appearance, characteristics such as solar panels or the condition of the property). – state-of-the-art fittings and condition), as well as the characteristics of its environment (for example, if the neighborhood has a high crime rate and / or is accessible to schools and the city center, the level of pollution of the water and air, or the value of other homes nearby).
The hedonic pricing model is used to estimate how much each factor affects the price of the home. When running the model, if non-environmental factors are controlled (kept stable), any remaining price divergence will represent differences in the external environment of the good. When it comes to property valuation, a hedonic pricing model is relatively simple because it is based on actual market prices and on available and complete data sets.
Hedonic pricing is used to determine to what extent environmental or ecosystem factors affect the price of a good, usually a house.
Advantages and disadvantages of hedonic pricing
The hedonic pricing model has many advantages, including the ability to estimate values, based on concrete choices, especially when applied to real estate markets with accurate and readily available data. At the same time, the method is flexible enough to be adapted to the relationships between other goods in the market and to external factors.
Hedonic pricing also has significant drawbacks, including its ability to capture only consumers’ willingness to pay for what they perceive to be environmental differences and their consequences. For example, if potential buyers are unaware of a contaminated water supply or an impending construction next to the morning, the price of the subject property will not change accordingly. Hedonic pricing also does not always incorporate external factors or regulations, such as taxes and interest rates, which could also have a significant impact on prices.
Example of hedonic pricing
Consider house prices, which are a simple way to assess certain environmental aspects. For example, a house near parks or schools can sell for a high price. Meanwhile, a house on a main highway may sell for less. Hedonic pricing uses regression to see which factors matter most and the relative importance of each.
For the example of the price of the house, the price of the house would be analyzed according to independent variables, such as the distance from a park. With that, the result would appear something along the lines of, for every mile closer to a park, the value of the house increases by $ 10,000.
Labor economist Sherwin Rosen presented a theory of hedonic pricing for the first time in 1974 in an article titled “Hedonic prices and implicit markets: product differentiation in pure competition”.