Title: Valuation 10: Hedonic Pricing
1Valuation 10 Hedonic Pricing
- A partial equilibrium model of prices, wages and
pollution - The hedonic price equation
- From hedonic prices to welfare
- Application Environmental hazards
2Last two weeks we looked at
- The household production function approach, which
assumes that certain observable behaviour is a
complement (e.g., travel to recreate) or
substitute (e.g., airbag for road safety) to
unobservable consumption of an environmental good
or service - A simple travel cost model of a single site
- Multiple sites
- Implementation
- The zonal travel cost method
- The individual travel cost model
- Travel cost with a random utility model
3The price of land
- The asset price equals the value of the stream of
services that the parcel can be expected to
provide in the future, netted back to the present - uncertainty about the future
- The rental price of land is the value of renting
for a short period - e.g., for agricultural land, the difference
between expected yield times prices minus the
costs of labour, seeds, pesticides etc - expectations about the future play little or no
role - Pollution degrades value and thus price
- What is the WTP to clean up the pollution?
4Starters
- What is the WTP to clean up pollution?
- Consider agricultural land in a valley, half of
which is upwind a polluting plant, the other half
downwind - If this is a small valley with a local market for
agricultural goods the land value change will not
fully capture the value for cleaner air - If this is a small valley in a large market the
difference between land value is a proxy of the
value of pollution - Consider an open city, with free mobility
- Utility must be the same everywhere
- So land prices exactly compensate for pollution
- In a closed city, reducing non-uniform pollution
would affect property values as well as utility
5Wages, land prices and pollution
- Arguably, pollution should suppress land prices
but we see that urban land is worth more than
rural land - Urban wages are also higher than rural wages do
wages rise to compensate for deteriorating
environmental quality? - We will construct a model of urban land prices,
wages and pollution -- first, analytically and
then well derive a function that can be estimated
6The consumer
- Consider a number of cities that have different
levels of pollution p firms produce a composite
good X (at price 1) and move about freely the
wage rate w and the land rent r vary between
cities - Consumers are identical, purchase X and land for
housing L - Each consumer has the utility maximization
problem - The utility level for a particular set of w, r
and p is - Assuming free movement, utility is the same
everywhere
7The producer
- In a constant cost industry, the average cost of
producing X equals the product price which is the
same for all cities - The price for the product is the same, but the
composition of inputs can differ - If rents are higher in one city, wages must be
lower to compensate, otherwise the firm would
relocate - Pollution may affect costs in different ways
- Unproductive (pollution hinders production)
- Productive (pollution regulation hinders
production) - Neutral (no affect on the firm, but wages and
rents affect production)
8Productive and unproductive pollution
Two cities with different pollution levels p2gt p1
- Cases A and B when pollution is productive wages
rise - Cases C and D when pollution is unproductive
land prices decrease
r
c(w,r,p2)1
c(w,r,p1)1
V(w,r,p1)k
V(w,r,p2)k
C
A
B
D
w
9Sum up
- Because the utility levels of the citizens must
be the same, higher pollution must be compensated
by either higher wages, lower land rents or both - If pollution is productive, the firm spends less
on pollution control - To keep costs constant for higher levels of
pollution, wages or land prices must rise - Putting consumers and producers together
- If pollution is productive, pollution raises
wages but has an ambiguous effect on land rents - If pollution is unproductive, pollution depresses
land prices but has an ambiguous effect on wages - If pollution is neutral, pollution decreases land
prices and increases wages
10Hedonic price theory
- In the real world we are often confronted with
bundles of goods with a single price for the
whole bundle - We are interested in the price of an element of
the bundle - This is the focus of the hedonic price theory
- By observing the prices of many houses with
different characteristics, we can infer the
implicit value that is being placed on one
characteristic, e.g. air quality - By observing wages associated with many different
occupations we can infer the value of small
changes in e.g. risk - Applied to prices of farmland as early as 1922
- Rosen (1974) developed the formal theory of
hedonic prices
11Hedonic price theory (2)
- Consider an homogenous area that can be
considered a single market from the point of view
of, say, houses - For simplification, each house is characterised
by a single characteristic, z, say, air pollution - We are interested in the relation between price
and air quality, p p(z) - The price function is an equilibrium concept
(partial equilibrium) resulting from interaction
of supply and demand - We assume that the market is perfect
- Both producers and consumers take p(z) as given
12The consumer
- The consumer buys one house as well as other
goods x - The consumers problem is
- What is the amount of x for particular values of
z to achieve a certain level of utility - The budget for buying the house, guaranteeing a
certain level of utility is - Alternatively, we can define the consumers
problem as - This is known as the bid function it tells you
the maximum amount a consumer is willing to pay
as a function of income and air pollution
13Consumer choice
- Hedonic price function and two bid functions for
two different levels of utility
p(z)
Q(y,z,U0)
Q(y,z,U1)
Utility increases
Air quality z
14The producer
- The costs c of producing one house depend on
input prices r and the characteristics z c(r,z) - The producer maximises profits
- Alternatively the price to obtain a certain level
of profit given a level of z is - This is known as the offer function it tells
you the minimum amount a producer is willing to
accept as a function of costs and air pollution
15Producer choice
- Hedonic price function and two offer functions
for two different levels of profit
F(r,z, p2)
Profits increase
F(r,z, p1)
p(z)
Air quality z
16Market equilibrium
In the equilibrium, the marginal bid, the
marginal offer, and the house price are identical
all parties in the market value the house the
same, at the margin
p(z)
F3
Q3
F2
Q2
F1
Q1
Air quality z
17Willingness to pay
/unit
Marginal implicit price function and marginal WTP
for one more unit of z for consumers 1 and 2
MWTP2(z)
MWTP1(z)
p(z)
Air quality z
18Sum up
- The hedonic price function tells you how price
varies with environmental quality and other
factors (income) - Take the derivative of the rental price to
environmental quality this gives the price of
environmental quality - This is the first-stage estimation procedure
- Do this for various income levels
- This gives the price of environmental quality as
a function of income that is, an inverse demand
function - This is the second-stage estimation procedure
- This assumes, that different individuals making
choices along the hedonic price function are
variants of the same person - As the second-stage estimation procedure uses no
additional data beyond the already contained in
the hedonic price function, it can only reproduce
the coefficients estimated from the hedonic price
function - Recent applications of the method estimate only
the first-stage
19Theory and practice
- Theory and practice differ substantially
- Niceties such as the difference between
compensated and uncompensated demand functions
are typically ignored - Critical assumptions
- Households have full information on all housing
prices and attributes, transaction and moving
costs are zero - Prices adjust instantaneously to changes
- Market distortions are ignored
- Only one market (housing) is analysed
- The reason data although wages and house prices
are known, it is hard to get data because of
privacy
20Application Environmental hazards
- Do environmental hazards such as the proximity to
a major fuel pipeline affect house prices? - Study by Hansen, Benson and Hagen (Land
Economics, 2006) - They use data for Bellingham, Washington,
- the site of a 1999 rupture and explosion and
compare housing prices before and after the
accident (1995-2004) - The results suggest that the event led to a
significant increase in perceived risk and
perhaps to an increase beyond the actual risk - Before the accident public awareness was low and
risks were irrelevant indicating a deviation
between perceived and actual risk
21Data and modelling strategy
- In Bellingham, two major transmission pipelines
run through residential area - The Olympic pipeline (refined petroleum) and the
Trans Mountain pipeline (crude oil) - On June 10, 1999, the Olympic pipeline ruptured,
spilling 229000 gallons of gasoline into the
Whatcom Creek - Sales of all houses located within one mile of
either pipeline was sampled for the period 1995
to 2004 - A number of housing characteristics were included
as well as the distance to a pipeline - To test the hypothesis (sales price are not
affected in the absence of an effect) they split
the sample to estimate the model for each
sub-sample, the pre-event and the post-event
sample
22Regression results
Significant at the 1 level significant at
the 5 level significant at the 10 level.
23As distance increases, sales price rises to the
average level
24The effect decays over time, but a significant
price effect remains