What is 'Hedonic Pricing'

Hedonic pricing is a model, which 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 ecosystem or environmental services that directly impact 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.

BREAKING DOWN 'Hedonic Pricing'

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. its 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).

The hedonic pricing model is used to estimate the extent to which each factor affects the price of the 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.

With regards to valuing properties, a hedonic pricing model is relatively straightforward as relies on actual market prices and comprehensive, available data sets.

Advantages and Limitations 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.

Origin of Hedonic Pricing Theory

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 he argued 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.

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