Valuation 5: Hedonic Pricing

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Valuation 5 Hedonic Pricing

• A partial equilibrium model of prices, wages and
  pollution
• The hedonic price equation
• From hedonic prices to welfare
• Applications Forests and earthquakes

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Last week we looked at

• The travel cost method, 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
• Before that, we looked at restricted demand
  theory and welfare measures, and contingent
  valuation stated preferences
• This week The other revealed preference method,
  looking at household consumption

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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
• 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
• Pollution degrades value and thus price

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Starters

• Consider agricultural land in a valley, half of
  which is upwind a polluting plant, the other half
  downwind the difference between land value is
  only an indication of the value of pollution if
  this is a small valley in a large market
• 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

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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 compensate for pollution?
• We will construct a model of urban land prices,
  wages and pollution -- first, analytically and
  then well derive a function that can be estimated

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Wages, Land Prices and Pollution -2

• 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 is w and the land rent r vary between
  cities
• Consumers are identical, purchase X and land for
  housing L
• Assuming free movement, utility is the same
  everywhere V(w,r,p)k

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Wages, Land Prices and Pollution -3

• In a constant cost industry, average production
  costs equal marginal production costs equal
  price, so that for all cities c(w,r,p)1
• Pollution may affect costs in different ways
• Unproductive (pollution hinders production)
• Productive (pollution regulation hinders prod.)
• Neutral (but wages and rents affect prod.)

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Wages, Land Prices and Pollution -4

• Higher pollution must be compensated by either
  higher wages or lower land rents
• Vk, p? ? w?, r?
• If pollution is productive, pollution raises
  wages but has an ambiguous effect on land rents
  c1, p? ? w?, r?
• If pollution is unproductive, pollution depresses
  land prices but has an ambiguous effect on wages
  c1, p? ? w?, r?
• If pollution is neutral, pollution decreases land
  prices and increases wages

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Hedonic Price Theory

• Consider an homogenous area that can be
  considered a single market from the point of view
  of, say, houses
• 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)
• We look at the partial equilibrium, and assume
  that the market is perfect

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Hedonic Price Theory -2

• The consumer buys exactly one house as well as
  other goods x
• Alternatively, we consider the budget for buying
  the house, guaranteeing a certain level of
  utility
• 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

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Hedonic Price Theory -3

• The producer maximises profits
• 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
• 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

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Hedonic Price Theory -4

• The hedonic price function tells you how price
  varies with environmental quality and other
  factors (income)
• Take the derivative of the price to environmental
  quality this gives the price of environmental
  quality
• Do this for various income levels
• This gives the price of env. quality as a
  function of income that is, an inverse demand
  function
• Sometimes direct, sometimes statistical

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Theory and practice

• Theory and practice differ substantially
• Niceties such as the difference between
  compensated and uncompensated demand functions
  are typically ignored
• Only one market (housing) is analysed
• Market distortions are ignored
• The reason data although wages and house prices
  are known, it is hard to get data because of
  privacy one can readily get ask prices for
  houses that are currently on offer, but not
  actual prices

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Application Earthquakes

• Does earthquake risk affect house prices?
• California designated Special Study Zones (SSZs)
  which are risky house owners know and tell
  potential buyers
• The price of house in these zones is 4650
  (2490) lower than that of identical house
  outside those zones in Los Angelos (San
  Francisco)
• This is half the price of a swimming pool, a
  third of a view
• Before notification, risks were irrelevant

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Ln(home sale price)
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Application Forests

• Do green areas affect house prices?
• The city of Salo, 32,000 inhabitants, in Finland
• About 10 of the area is green
• 590 appartments in terraced houses were sold
  between 1984-1986
• The sale price was regressed on size, distance to
  city centre, distance to Nokia, age, forest view,
  type of house, and distance to nearest green area
  (based on satellite images)

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