Hedonic Pricing

Hedonic pricing is a method of estimating the value of the characteristics of a good, by regressing its price on the quantities of the characteristics that it embodies. The method is used in the construction of price indices, in the valuation of non-market goods, and in the analysis of consumer preferences.

Method

The hedonic method models the price of a good as a function of its characteristics. For a house, the characteristics might include the number of rooms, the size of the plot, the age of the building, and the location. For a computer, they might include the processor speed, the memory, and the storage capacity.

The estimated coefficients represent the implicit prices of the characteristics, which are the amounts that the market is willing to pay for additional units of each. The coefficients can be used to construct quality-adjusted prices, by holding the characteristics constant.

The method requires a data set that includes the prices and the characteristics of a sample of goods. The functional form of the relationship must be specified, and the choice of form affects the results. The method also requires attention to the potential for correlation between the characteristics and unobserved factors that affect price.

Quality Adjustment

The hedonic method is used in the construction of price indices to adjust for changes in quality. When the quality of a good improves, a simple price index that does not account for the improvement will overstate the rate of inflation, since the price increase may reflect the improvement rather than a change in the value of money.

The hedonic method addresses this problem by estimating the value of the quality change and adjusting the price accordingly. The adjusted prices are then used to construct the index, which measures the change in the price of a constant-quality good.

The method is used for goods whose characteristics change rapidly, including computers, electronic equipment, and automobiles. Its use has been extended to services, including housing and medical care, though the measurement of quality in services is more difficult.

Applications

The hedonic method is used in the valuation of non-market goods, particularly environmental quality. The value of clean air, of quiet, or of proximity to amenities can be inferred from the prices of houses, which reflect the characteristics of the location.

The method is also used in the analysis of consumer preferences, since the implicit prices reveal the marginal valuations of the characteristics. The analysis of these valuations informs the design of products and the assessment of market power.

The method is used in the regulation of utilities, where it informs the assessment of the quality of service and the design of price caps. It is used in the construction of productivity measures, since the adjustment for quality affects the measurement of output and of productivity.

Limitations

The hedonic method has limitations. It requires data on the characteristics of goods, which may not be available or may be measured with error. It assumes that the market is in equilibrium, so that the observed prices reflect the valuations of the characteristics, which may not hold in the short run.

The method is also sensitive to the specification of the model. The results depend on the choice of characteristics, on the functional form, and on the treatment of unobserved factors. The interpretation of the coefficients therefore requires care.

The Theory Behind the Method

The hedonic method is grounded in the theory of consumer choice. Consumers value goods for the characteristics that they embody, and the price of a good is the sum of the values of its characteristics, weighted by the quantities that it contains.

The implicit prices of the characteristics are revealed by the market, since they are the amounts that consumers are willing to pay for additional units of each characteristic. The analysis of these prices provides information about the preferences of consumers and about the valuation of quality.

The theory also recognises that the characteristics of goods are not always observable, and that the prices reflect both the observed characteristics and the unobserved quality. The method must therefore account for the unobserved factors, which is a source of difficulty.

Quality-Adjusted Price Indices

The construction of quality-adjusted price indices is one of the main applications of the hedonic method. The objective is to measure the change in the price of a constant-quality good, so that the index reflects the change in the value of money rather than the change in the quality of the goods.

The method is used for goods whose characteristics change rapidly, including computers and other electronic products. The prices of these goods fall rapidly in quality-adjusted terms, even when the nominal prices are stable or rising, and a simple index that ignores quality would substantially overstate inflation.

The adjustment affects the measurement of real output and of productivity. An index that does not adjust for quality understates the growth of real output, since it treats an improvement in quality as an increase in price. The use of hedonic methods therefore raises the measured rate of growth.

Environmental Valuation

The hedonic method is used to value environmental amenities, by examining the effect of environmental quality on the prices of houses. The approach assumes that the prices of houses reflect the characteristics of the location, including the quality of the air, the level of noise, and the proximity to amenities.

The method has been used to estimate the value of clean air, of quiet, and of access to parks. The estimates are used in the assessment of the benefits of environmental policy, and they inform the design of regulation.

The method is subject to limitations, including the assumption that the housing market is in equilibrium and that the prices reflect the valuations of the amenities. The estimates are also sensitive to the specification of the model and to the treatment of unobserved factors.

Summary

Hedonic pricing is a versatile method for estimating the value of quality, and it is used in the construction of price indices, in the valuation of environmental amenities, and in the analysis of consumer preferences. Its application requires careful attention to the specification of the model and to the interpretation of the results.

See also

• Market Basket
• Consumer Behaviour
• Statistics