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Valuation 10: Hedonic Pricing

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Valuation 10: Hedonic Pricing A partial equilibrium model of prices, wages and pollution The hedonic price equation From hedonic prices to welfare – PowerPoint PPT presentation

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Title: Valuation 10: Hedonic Pricing


1
Valuation 10 Hedonic Pricing
  • A partial equilibrium model of prices, wages and
    pollution
  • The hedonic price equation
  • From hedonic prices to welfare
  • Application Environmental hazards

2
Last 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

3
The 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?

4
Starters
  • 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

5
Wages, 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

6
The 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

7
The 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)

8
Productive 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
9
Sum 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

10
Hedonic 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

11
Hedonic 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

12
The 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

13
Consumer 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
14
The 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

15
Producer 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
16
Market 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
17
Willingness 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
18
Sum 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

19
Theory 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

20
Application 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

21
Data 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

22
Regression results
Significant at the 1 level significant at
the 5 level significant at the 10 level.
23
As distance increases, sales price rises to the
average level
24
The effect decays over time, but a significant
price effect remains
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