Hedonic Pricing is a method to determine the price of a good using its characteristics. The approach can be used to determine the price of a good using the characteristics and prices of related goods. Hedonic pricing is used in a lot of different contexts. For example, hedonic is used in housing markets to determine the price of houses. It is also used in the context of inflation estimation. We will discuss both these cases in more detail below.
Hedonic pricing was introduced by Sherwin Rosen in a paper called “Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition“. In the paper he argued that a good’s value is the sum of the parts, where the value of the parts of course depend on consumers’ willingness to pay for the characteristics.
On this page, we discuss the hedonic pricing method, explain two widely used hedonic pricing model examples (hedonic methods in housing markets and hedonic price index methods).
Hedonic pricing Definition
What is hedonic pricing? Formally, hedonic pricing can be best described as using the prices and product characteristics of related products to determine the price of a specific good. Suppose we know the price for a bottle of wine and we want to determine its value. Clearly the year, color, and origin matter.
While we don’t have the price for a bottle of red Bordeaux wine, we do have a lot of prices for other wines for various years, origins, both for red and white wines. Using hedonic prices, we can use the characteristics and prices of those wines to estimate a fair price for the wine we want to price. This is the basic principle behind hedonic pricing. Now let’s consider a few hedonic pricing method examples.
Hedonic Pricing Model for Housing
The hedonic pricing model for housing is used to value a house. This is typically done by the real estate agent to determine an appropriate price for a house. Since every house is different, the real estate agent can’t just use the same price for all the houses that he has on sale. Thus, he needs to estimate the price of the house based on its characteristics.
Clearly, a house has a number of important characteristics that determine its value. For example, the number of bedrooms, the number of bathrooms, the location, the building year, etc. Using a big data set on similar houses, the real estate agent can determine how all these characteristics impact the final price.
In practice, the best way a hedonic valuation method is implemented is using a hedonic regression. In that case, the price of the house is the dependent variable and the characteristics are the explanatory variables. An example of such a model may look as follows:
where price is the price of the house, BD is the number of bedrooms, Loc is the neighbourhood where the house is located, and Year is the construction year.
Once the model is estimated, the estimated parameters can be used to predict the price for the house we want to put a price on. Hedonic analysis of housing markets is done using exactly this method.
Hedonic Price index
A second important case is hedonic pricing of CPI. In this case, hedonic pricing is used to adjust the prices of goods whose characteristics have changed over time. Let’s take an example. Prices for smartphones are higher today than a few years ago. If we would include the prices of smartphones in a consumer price index, inflation would increase. But is the price increase really the result of inflation? A smartphone today can do a lot more than a smartphone five years ago. So maybe the higher price is justified. Thus, what economists will typically do is correct the price of the smartphone for changes in quality.
The advantage of applying hedonic pricing in the context of CPI estimation is that we avoid changes in the prices of goods due to changes in quality from impacting inflation.
On this page we discussed two important examples of hedonic pricing. In particular, we discussed hedonic methods in housing markets and hedonic price index methods.