What is Hedonic Pricing?
Hedonic pricing – or the hedonic pricing method – is used in the determination of the economic value for an ecosystem service or external factor that may influence the market price of a good or asset. The method is commonly applied in the valuation of properties, such as houses, and accounts for economic costs or benefits, which may influence the overall value of the asset or, as commonly presumed, a house. Hedonic price valuation is very quantitative and relies on statistical analysis and informed model specifications.
When valuing a property, hedonic pricing allows for housing prices to be estimated by using more than one variable, for example, the property’s features, the location features, and the environmental characteristics. Through regression analysis, the importance and weight of the explanatory variables and their influence on the overall value of a property can be determined.
- Hedonic pricing – or the hedonic pricing method – is used in the determination of the economic value for an ecosystem service or services that may influence the market price of a good or asset.
- The method is commonly applied in the valuation of properties, such as houses, and accounts for economic costs or benefits, which may influence the overall value of the asset or, as commonly presumed, a house.
- The hedonic pricing model is common in the housing sector because of its flexibility and ability to accommodate various factors and parameters in the determination of a fair property price.
Hedonic Regression and Analysis Models
There are two parts to performing hedonic regression analysis.
- The initial step is determining the relationship between an asset’s value or price (which would be the dependent variable in the analysis) and the independent explanatory variables (which are the characteristics, including the property’s features, the location features, and the environmental features).
- The price variation, which occurs due to changes in any of the property or asset’s characteristics, is called the hedonic price. The hedonic price of an asset can be called the asset’s additional cost, based on the additional benefit derived from the property’s features.
- The second part of hedonic regression is the analysis of the households’ willingness to pay, with consideration of their income and preferences. The willingness to pay is derived from the size of the property, the income of a household, and preferences based on individual characteristics, which include age, family size, race, and social background, etc.
Benefits of the Hedonic Pricing Method
The hedonic pricing method can be applied to determine values and derive conclusions based on definite choices. The general assumption that property markets change and respond to new or existing information supports the efficiency and reliability of value indication through the model. The model is adaptable and can be structured in a way that accounts for numerous probable connections between an asset or property and environmental quality, among other external factors.
Overall, the hedonic pricing method allows for a fair value determination of a property because it accounts for various external factors that can potentially influence the price of the asset, and it allows for a simplified justification for price variations due. The model is common in the housing sector because of its flexibility and ability to accommodate various factors and parameters in the determination of a fair property price.
Limitations of Hedonic Pricing Models
There are five notable drawbacks of using hedonic pricing methods. They include (but may not be limited to) information availability and knowledge, validation of measurements, market limitations, multicollinearity, and price fluctuations.
Concerning Information and knowledge, hedonic models assume and necessitate the need for all concerned individuals to have information regarding all positive and negative property features that may impact the purchase of a property. It is not always the case in reality.
Regarding the validation of measurements, it is important for the independent variable measures to be of superiority and not based on proxy measures, which may result in model result inaccuracies – i.e., inaccurate coefficient generation.
Moreover, market limitations are considered to be a drawback to the hedonic pricing model as it assumes that there are various properties available and that individuals can select their preferred property based on their preferred property features. However, it is not always the case. Multicollinearity can occur in hedonic pricing models because it may be challenging to separate certain variables.
Furthermore, hedonic pricing models follow the assumption that market prices change following changes in attributes; however, in practicality, prices may lag.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: