What Is Hedonic Regression?
Hedonic regression is a revealed-preference method used in economics and consumer science to determine the relative importance of the variables which affect the price of a good or service. These factors are determined using regression analysis.
The hedonic pricing regression is used to estimate the extent to which several factors affect the price of a product or a piece of real estate like a home. When running the model, if non-environmental factors are controlled for (held steady), any remaining discrepancies in price will represent differences in the good’s external surroundings.
The Basics of Hedonic Regression
Hedonic regression is used in hedonic pricing models and is commonly used in real estate, retail, and economics. For example, if the price of a house is determined by different characteristics, like the number of bedrooms, the number of bathrooms, proximity to schools, etc., regression analysis can be used to determine the relative importance of each variable.
The most common example of the hedonic pricing method is in the housing market, wherein the price of a building or piece of land is determined by the characteristics of the property itself (e.g., size, appearance, features like solar panels or state-of-the-art faucet fixtures, and condition), as well as characteristics of its surrounding environment (e.g., 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).
Hedonic regression models pragmatically regress the price of one unit of a commodity (a “model” or “box”) on a function of the characteristics of the model and a time dummy variable. It is assumed that a sample of model prices can be collected for two or more time periods along with a vector of the associated model characteristics.
Hedonic regression is also used in consumer price index (CPI) calculations, to control for the effect of changes in product quality. The hedonic quality adjustment method removes any price differential attributed to a change in quality by adding or subtracting the estimated value of that change from the price of the old item.
Origin of Hedonics
In 1974, Sherwin Rosen first presented a theory of hedonic pricing in his paper, “Hedonic Pricing and Implicit Markets: Product Differentiation in Pure Competition,” affiliated with the University of Rochester and Harvard University. In the publication, Rosen argues that an item’s total price can be thought of as a sum of the price of each of its homogeneous attributes. An item’s price can also be regressed on these unique characteristics to determine the effect of each characteristic on its price.