Hedonic regression
Encyclopedia
In economics
, hedonic regression or hedonic demand theory is a revealed preference
method of estimating demand
or value
. It decomposes the item being researched into its constituent characteristics, and obtains estimates of the contributory value of each characteristic. This requires that the composite good being valued can be reduced to its constituent parts and that the market values those constituent parts. Hedonic models are most commonly estimated using regression analysis
, although more generalized models, such as sales adjustment grid
s, are special cases of hedonic models.
An attribute vector, which may be a dummy or panel variable, is assigned to each characteristic or group of characteristics. Hedonic models can accommodate non-linearity, variable interaction, or other complex valuation situations.
Hedonic models are commonly used in real estate appraisal
, real estate economics
and Consumer Price Index
(CPI) calculations. In CPI calculations hedonic regression is used to control the effect of changes in product quality. Price changes that are due to substitution effects are subject to hedonic quality adjustments.
This method finds its application to reveal the effect of environmental attributes in changes in the local real estate
pricing. It is frequently used for estimating costs related to:
It is important to note that the hedonic pricing method is based on the fact that prices of goods in a market are affected by their characteristics. For example, the price of a pair of pants will depend on the comfort, the cloth used, the brand, the fit, etc. So this method helps us estimate the value of a commodity based on people’s willingness to pay
for the commodity as and when its characteristics change.
A particular example which is used most often is the real estate market where the value of two different properties (which can otherwise be compared) will vary depending on the various environmental amenities present in the surrounding areas of these properties.
If there is a measurable price drop of properties located near a dump yard (as compared to other locations), the difference in the prices point towards the external cost of the dump yard. It is the marginal willingness to pay (in higher housing prices) for the given difference in cleanliness and serenity of the locality. Hedonic Regression methods are used to estimate these price differentials.
The Hedonic Pricing Method (HPM) as mentioned earlier is a form of revealed preference method of valuation and it uses surrogate markets to estimate the value of the environmental amenity.
Surrogate market is a concept uses when one cannot directly estimate the market prices for certain environmental good
s. So another good sold in the market which is related to the non-marketed environmental good is chosen.
For example, if we want to know the value of clean air estimated by an individual, he may reveal his preference in the form of establishing his house in a clean society and paying an extra premium for the same. Thus, with the help of Hedonic Pricing Method, the environmental component of the value and the market price can be separated. In turn, this market price is used a surrogate for the environmental value.
The Uniform Standards of Professional Appraisal Practice
, or USPAP, provides for mass appraisal standards to govern the use of hedonic regressions and other automated valuation models when used for real estate appraisal
. Appraisal methodology treats the hedonic regression as essentially a statistically robust form of the sales comparison approach
. Hedonic models are commonly used in tax assessment, litigation, academic studies, and other mass appraisal projects.
The price of a house will thus be affected by the structural characteristics (s1, s2, s3...) of the house itself, characteristics of the locality/neighbourhood (n1, n2, n3...), and environmental characteristics (e1, e2, e3...)
Structural Characteristics could be anything from size of the house, to the number of rooms, type of flooring, etc. Neighbourhood attributes include variables like posh-ness of the locality, quality of roads, etc. And the environmental characteristics are variables such quality of air, proximity to parks, beaches, dumping yards, etc.
The analysis takes place in two stages.
The first stage involves employing regression techniques to estimate the Hedonic Price Function of the property. This function will relate the prices of many properties in the same housing area to the different characteristics.
So Price Function (P) = f (s1, s2, s3...sj; n1, n2, n3,...nj; e1, e2, e3,...ej)
This function could be linear
or non-linear. The prices may change at an increasing or decreasing rate when the characteristics change.
When you now differentiate the price function with respect to any one of the above characteristics, the implicit price function for that particular characteristic is yielded. It is considered implicit because the price function is indirectly revealed to us by what the people are willing to pay in order to obtain better quality or quantities of the characteristic.
In the second stage, these implicit prices are regressed against the actual quantities/qualities chosen by the people in order to attain the marginal willingness to pay
for the amenity
. The results of this analysis will indicate the changes in property values for a unit change in each characteristic, given that all the other characteristics are constant. Some variables however may be correlated. This will result in similar changes in their values.
cost of living adjustments.
However, the same use of hedonic models when analyzing consumer prices in other countries has shown that non-hedonic methods may misstate inflation over time by failing to take quality changes into account.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, hedonic regression or hedonic demand theory is a revealed preference
Revealed preference
Revealed preference theory, pioneered by American economist Paul Samuelson, is a method by which it is possible to discern the best possible option on the basis of consumer behavior. Essentially, this means that the preferences of consumers can be revealed by their purchasing habits...
method of estimating demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
or value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
. It decomposes the item being researched into its constituent characteristics, and obtains estimates of the contributory value of each characteristic. This requires that the composite good being valued can be reduced to its constituent parts and that the market values those constituent parts. Hedonic models are most commonly estimated using regression analysis
Regression analysis
In statistics, regression analysis includes many techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables...
, although more generalized models, such as sales adjustment grid
Sales comparison approach
The sales comparison approach is one of the three major groupings of valuation methods, called the three approaches to value, commonly used in real estate appraisal. This approach compares a subject property's characteristics with those of comparable properties which have recently sold in similar...
s, are special cases of hedonic models.
An attribute vector, which may be a dummy or panel variable, is assigned to each characteristic or group of characteristics. Hedonic models can accommodate non-linearity, variable interaction, or other complex valuation situations.
Hedonic models are commonly used in real estate appraisal
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
, real estate economics
Real estate economics
Real estate economics is the application of economic techniques to real estate markets. It tries to describe, explain, and predict patterns of prices, supply, and demand...
and Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
(CPI) calculations. In CPI calculations hedonic regression is used to control the effect of changes in product quality. Price changes that are due to substitution effects are subject to hedonic quality adjustments.
Hedonic pricing method
Certain environmental services often influence the market prices. The Hedonic pricing method is often brought into play in order to assess the economic values of such services.This method finds its application to reveal the effect of environmental attributes in changes in the local real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
pricing. It is frequently used for estimating costs related to:
- The overall quality of the environment in terms of air pollutionAir pollutionAir pollution is the introduction of chemicals, particulate matter, or biological materials that cause harm or discomfort to humans or other living organisms, or cause damage to the natural environment or built environment, into the atmosphere....
, water pollutionWater pollutionWater pollution is the contamination of water bodies . Water pollution occurs when pollutants are discharged directly or indirectly into water bodies without adequate treatment to remove harmful compounds....
and noise - Environmental amenities which include aesthetic sights and closeness to recreational sites such as parks, beaches, etc.
It is important to note that the hedonic pricing method is based on the fact that prices of goods in a market are affected by their characteristics. For example, the price of a pair of pants will depend on the comfort, the cloth used, the brand, the fit, etc. So this method helps us estimate the value of a commodity based on people’s willingness to pay
Willingness to pay
In economics, the willingness to pay is the maximum amount a person would be willing to pay, sacrifice or exchange in order to receive a good or to avoid something undesired, such as pollution...
for the commodity as and when its characteristics change.
A particular example which is used most often is the real estate market where the value of two different properties (which can otherwise be compared) will vary depending on the various environmental amenities present in the surrounding areas of these properties.
If there is a measurable price drop of properties located near a dump yard (as compared to other locations), the difference in the prices point towards the external cost of the dump yard. It is the marginal willingness to pay (in higher housing prices) for the given difference in cleanliness and serenity of the locality. Hedonic Regression methods are used to estimate these price differentials.
The Hedonic Pricing Method (HPM) as mentioned earlier is a form of revealed preference method of valuation and it uses surrogate markets to estimate the value of the environmental amenity.
Surrogate market is a concept uses when one cannot directly estimate the market prices for certain environmental good
Environmental good
Environmental goods are a sub-category of public goods which includes:* Clean air* Clean water* Landscape* Scenic towns* Green transport infrastructure * A diverse flora* A diverse fauna* Public parks...
s. So another good sold in the market which is related to the non-marketed environmental good is chosen.
For example, if we want to know the value of clean air estimated by an individual, he may reveal his preference in the form of establishing his house in a clean society and paying an extra premium for the same. Thus, with the help of Hedonic Pricing Method, the environmental component of the value and the market price can be separated. In turn, this market price is used a surrogate for the environmental value.
Hedonic models and real estate valuation
In real estate economics, it is used to adjust for the problems associated with researching a good that is as heterogeneous as buildings. Because buildings are so different, it is difficult to estimate the demand for buildings generically. Instead, it is assumed that a house can be decomposed into characteristics such as number of bedrooms, size of lot, or distance to the city center. A hedonic regression equation treats these attributes (or bundles of attributes) separately, and estimates prices (in the case of an additive model) or elasticity (in the case of a log model) for each of them. This information can be used to construct a price index that can be used to compare the price of housing in different cities, or to do time series analysis. As with CPI calculations, hedonic pricing can be used to correct for quality changes in constructing a housing price index. It can also be used to assess the value of a property, in the absence of specific market transaction data. It can also be used to analyze the demand for various housing characteristics, and housing demand in general. It has also been used to test assumptions in spatial economics.The Uniform Standards of Professional Appraisal Practice
Uniform Standards of Professional Appraisal Practice
Uniform Standards of Professional Appraisal Practice, commonly referred to by the acronym USPAP, can be considered the quality control standards applicable for real property, personal property, intangibles, and business valuation appraisal analysis and reports in the United States and its territories...
, or USPAP, provides for mass appraisal standards to govern the use of hedonic regressions and other automated valuation models when used for real estate appraisal
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
. Appraisal methodology treats the hedonic regression as essentially a statistically robust form of the sales comparison approach
Sales comparison approach
The sales comparison approach is one of the three major groupings of valuation methods, called the three approaches to value, commonly used in real estate appraisal. This approach compares a subject property's characteristics with those of comparable properties which have recently sold in similar...
. Hedonic models are commonly used in tax assessment, litigation, academic studies, and other mass appraisal projects.
Application of the Hedonic Pricing Method
While studying the application of the Hedonic Pricing Method, the first assumption made is the value of a house is affected by a particular combination of characteristics that it possesses given that properties with better qualities demand higher prices as compared to properties with lower qualities. This is the Hedonic Pricing Function.The price of a house will thus be affected by the structural characteristics (s1, s2, s3...) of the house itself, characteristics of the locality/neighbourhood (n1, n2, n3...), and environmental characteristics (e1, e2, e3...)
Structural Characteristics could be anything from size of the house, to the number of rooms, type of flooring, etc. Neighbourhood attributes include variables like posh-ness of the locality, quality of roads, etc. And the environmental characteristics are variables such quality of air, proximity to parks, beaches, dumping yards, etc.
The analysis takes place in two stages.
The first stage involves employing regression techniques to estimate the Hedonic Price Function of the property. This function will relate the prices of many properties in the same housing area to the different characteristics.
So Price Function (P) = f (s1, s2, s3...sj; n1, n2, n3,...nj; e1, e2, e3,...ej)
This function could be linear
Linear
In mathematics, a linear map or function f is a function which satisfies the following two properties:* Additivity : f = f + f...
or non-linear. The prices may change at an increasing or decreasing rate when the characteristics change.
When you now differentiate the price function with respect to any one of the above characteristics, the implicit price function for that particular characteristic is yielded. It is considered implicit because the price function is indirectly revealed to us by what the people are willing to pay in order to obtain better quality or quantities of the characteristic.
In the second stage, these implicit prices are regressed against the actual quantities/qualities chosen by the people in order to attain the marginal willingness to pay
Willingness to pay
In economics, the willingness to pay is the maximum amount a person would be willing to pay, sacrifice or exchange in order to receive a good or to avoid something undesired, such as pollution...
for the amenity
Amenity
In real property and lodging, amenities are any tangible or untangible benefits of a property, especially those that increase its attractiveness or value or that contribute to its comfort or convenience...
. The results of this analysis will indicate the changes in property values for a unit change in each characteristic, given that all the other characteristics are constant. Some variables however may be correlated. This will result in similar changes in their values.
Advantages
- Versatility: The method can be comfortable adapted to take into consideration the several probable interactions between environmental quality and the marketed goods.
- This method is often used to approximate the values based the actual choices of the people.
- The real estate market is a good indication of the values as it is relatively efficient in responding to information.
- It is comparatively easier to obtain data on property sales and characteristics and can be easily compared to secondary data sources in order to acquire the descriptive variables for the regression analysis.
Limitations
- The scope of applying this model is restricted and limited to measuring the environmental benefits related to housing prices only.
- The amount of data that needs to be collected and worked with is very large.
- A prerequisite of the model is that everyone should have prior knowledge of the potential positive and negative externalities that are associated with purchasing the real estate property. For example, it is important that they know before-hand about the level of pollution in a locality situated near an industrial site. This however is not the case in reality.
- The availability and accessibility of data directly affects the amount of time and the expense that will be undertaken to carry out an application of the model.
- This method estimates people’s willingness to pay for the supposed variation in environmental qualities and their consequences. However, if the people are unaware of the relation between the environmental qualities and their benefits to them or the property, then the value will not be reflected in the price of the property.
- Market Limitations: This model makes an assumption that, given their income, people have the opportunity to choose the combination of attributes they prefer. What it fails to see is that the real estateReal estateIn general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
market can also be affected by external factors such as interest rates, taxation, etc. For example : Suppose a family wishes to purchase a property near a popular city center, having a garden and of a large area. In reality - it may be possible that a house near the city center is comparatively smaller in size or does not have a garden. - MulticollinearityMulticollinearityMulticollinearity is a statistical phenomenon in which two or more predictor variables in a multiple regression model are highly correlated. In this situation the coefficient estimates may change erratically in response to small changes in the model or the data...
: Sometimes, there could be a case when Larger properties are only available in cleaner non-polluted areas and smaller properties are found in more urban and polluted environments. In such cases, it would be difficult to separate pollutionPollutionPollution is the introduction of contaminants into a natural environment that causes instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution can take the form of chemical substances or energy, such as noise, heat or light...
and the size of property exactly. - Price Changes: Another assumption is that prices in the market will automatically adjust to any changes in the attributes. In reality, there is a lag especially in localities where purchase and sale of real estate is limited.
- The model is relatively complex to interpret and requires a high level of statistical knowledge and expertise.
Criticism
Some commentators, including Austrian economists, have criticized the US government's use of hedonic regression in computing its CPI, fearing it can be used to mask the "true" inflation rate and thus lower the interest it must pay on Treasury Inflation-Protected Securities (TIPS) and Social SecuritySocial Security (United States)
In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...
cost of living adjustments.
However, the same use of hedonic models when analyzing consumer prices in other countries has shown that non-hedonic methods may misstate inflation over time by failing to take quality changes into account.