Hedonic pricing is a model that identifies price factors according to the premise that price is determined both by internal characteristics of the good being sold and external factors affecting it. A hedonic pricing model is often used to estimate quantitative values for environmental or ecosystem services that directly affect market prices for homes. This method of valuation can require a strong degree of statistical expertise and model specification, following a period of data collection.
Key Takeaways
- Hedonic pricing identifies the internal and external factors and characteristics that affect an item’s price in the market.
- Hedonic pricing is most often seen in the housing market since real estate prices are determined by the characteristics of the property itself as well as the neighborhood or environment within which it exists.
- Hedonic pricing captures a consumer’s willingness to pay for what they perceive are environmental differences that add or detract from the intrinsic value of an asset or property.
Understanding Hedonic Pricing
The most common example of the hedonic pricing method is in the real estate market, wherein the price of a building or piece of land is determined by the characteristics of both the property itself (i.e. internal factors like its size, appearance, features like solar panels or state-of-the-art faucet fixtures, and condition) as well as characteristics of its surrounding environment (i.e. external factors such as if the neighborhood has a high crime rate and/or is accessible to schools and a downtown area, the level of water and air pollution, or the value of other homes close by).
The hedonic pricing model is used to estimate the extent to which each factor affects the market price of the property. When running this type of model, if non-environmental factors are controlled for (held steady), any remaining discrepancies in price will represent differences in the good’s external surroundings. With regard to valuing properties, a hedonic pricing model is relatively straightforward as it relies on actual market prices and comprehensive, available data sets. Hedonic pricing is used to determine the extent that environmental or ecosystem factors affect the price of a good—usually a home.
Advantages and Disadvantages of Hedonic Pricing
The hedonic pricing model has many advantages, including the ability to estimate values, based on concrete choices, particularly when applied to property markets with readily available, accurate data. At the same time, the method is flexible enough to be adapted to relationships among other market goods and external factors.
Hedonic pricing also has significant drawbacks, including its ability to only capture consumers’ willingness to pay for what they perceive are environmental differences and their resulting consequences. For example, if potential buyers are not aware of a contaminated water supply or impending early morning construction next door, the price of the property in question 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.
Inspiring Example of Hedonic Pricing
Consider home prices, which provide a clear representation of valuing certain environmental aspects. For instance, a home close to parks or schools may sell for a premium, while a home near a major highway may sell for less. Hedonic pricing uses regression analysis to determine which factors matter most and the relative importance of each.
For example, the price of a home could be analyzed based on independent variables, such as distance from a park. The results might show that for every mile closer to a park, the home value increases by $10,000. Labor economist Sherwin Rosen first presented a theory of hedonic pricing in 1974 in a paper entitled Hedonic Pricing and Implicit Markets: Product Differentiation in Pure Competition.
Related Terms: Market Price, Environmental Economics, Regression Analysis, Property Valuation, Consumer Behavior.
