Hedonic Pricing Model (Definition, Formula) | Top 2 Examples with Explanation

Hedonic Pricing Model Definition

Hedonic Pricing Model is defined as a pricing model of the goods sold which takes into consideration the Internal as well as external factors. It was invented by Sherwin Rosen, a labor economist in 1974 in a paper named “ hedonic pricing- implicit markets”. This model is generally used in the housing industry to determine the prices of the homes based on internal and external characteristics.

The pricing as per the hedonic pricing model may change as per the parameters used in the analysis. some may give more weight to the external environment and less to the internal like the interior of the house etc.
Some may give lesser weightage to the external environment and more to the internal like house structure, interior, facilities available, etc.
Hence this pricing may differ from customer to customer and from one builder to another.
It gives a strong picture of the pricing analysis by analyzing a large amount of data.
It also takes into account the environmental and macroeconomic factors to derive the correct price of the goods.

Examples of Hedonic Pricing Model

Below are the examples of the Hedonic Pricing Model

Example #1

The housing industry is the best example to understand the hedonic pricing model. In this, the value of the house depends upon many characteristics like the carpet area, number of rooms, location, builder, floor number, transportation, railway station, etc. These factors will have weights in the valuation of the house since these are very essential for any buyer who wants to buy a house.

Location A: Established Builder, 2 bedroom house, nearby railway station, school and 5 minutes from the highway.
Location B: New Builder, 2 bedroom house, 20 minutes from the railway station.

Solution

In the above case, location a will be costlier as compared to location b since the nearby railway station will have an impact on the pricing of both the houses as consumers will prefer location as compared to location B since transport is easily available to them providing flexibility. Since location B is a faraway place, the buyer would be ready to spend more since it will save his time on a daily basis to travel to the nearest railway station to come to the office.

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This would force the builder to push the price up for location a since many buyers would look at it as their primary option and he can win over location B. The premium charged to location a termed as the hedonic pricing valuation model which has considered external factors to push up the price of the house and get good market share by marketing this fact.

Example #2

Location A: 2 bedroom house, Fully residential area, pollutants dumping yard 5 minutes away.
Location B: 2 bedroom house. full residential.

Solution

In this case, Location B will have a preference over the location and it will be highly priced only because customers will not want to buy a house near a dumping yard. The buyer would prefer to live in location B and pay more for the same house will similar features and characteristics since it will be a decent locality to live in without any other elements.

Advantages

Below mentioned are some of the major advantages of the Hedonic Pricing

It focuses more on the consumption patterns of the customers and has the ability to price fairly.
It takes into account both internal and external factors that will affect the decision making of the buyer.
Gives more preference to the likes and dislikes of the buyer to buy a house.
A 360-degree approach in order to price a particular product.

Disadvantages

It does not take into account the information which is hidden from the buyer of the house in order to inflate the price. Eg: If there is a water problem in the locality in spite of being a good location it may face opposition from the buyers. Hence by not disclosing the fact, the builder may keep the price intact of the house.
It sometimes does not take into account the interest rates and other taxes that can have a massive impact on the pricing.
Changing government policies can be very difficult to derive a price.
A costlier process to execute

Limitations

It gives more weight to external macro factors thus ignoring the internal ones which might be of more weight.
A complex model to execute.

Points to Note

Since it is more concerned about the external factors the model should be in such a way that equal weights are been given to both of them.

Conclusion

Hedonic pricing is one of the important types of pricing model that reflects the fair value of the product by taking into account many factors that will have an impact on the price of the product. By this kind of model, it is easy to justify the increase in price due to certain elements that play an important role in this. Thus it is more common in the housing sector since the same is very much flexible in fixing the right price for the house depending upon the parameters & other factors.