Hedonic Pricing

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Hedonic Pricing Model Definition

The hedonic pricing model is defined as a pricing model of the goods sold that considers the internal and external factors. This model is generally used in the housing industry to determine the prices of homes based on internal and external characteristics.

Hedonic Pricing

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The hedonic pricing approach gives a strong picture of the pricing analysis by analyzing a large amount of data. It also considers the environmental and macroeconomic factors Macroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more to derive the goods’ correct price. It gives more weight to external macro factors, thus ignoring the internal ones that might be more weight, and is a more complex model to execute.

Key Takeaways

  • The hedonic pricing model is a pricing model that takes into account both internal and external factors to determine the value of a good or service.
  • Labor economist Sherwin Rosen proposed it in his 1974 paper “Hedonic Prices and Implicit Markets.”
  • The model is commonly used in the housing industry to determine the price of a home based on various factors such as location, size, and amenities.
  • The hedonic pricing model is important because it helps determine a product’s fair value based on various factors that affect its price, making it a flexible and useful tool in many pricing contexts.

Hedonic Pricing Model Explained

Hedonic pricing is one of the important types of pricing models that reflects the fair value of the product by taking into account many factors that will impact the price of the product. This kind of model makes it 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 flexible in fixing the right price for the house depending upon the parameters and other factors.

The hedonic pricing method states how pricing may change as per the parameters used in the analysis. For example, some may give more weight to the external environment and less to the internal, like the house’s interior, etc.

The hedonic pricing theory  was talked about by Sherwin Rosen, a labor economist, in 1974 in a paper named “Hedonic Prices and Implicit Markets.” According to this, some may provide less weightage to the external environment and more internal like house structure, interior, available facilities, etc. This pricing, therefore, may differ from customer to customer and from one builder to another.

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Steps

The hedonic pricing analysis involves two steps:

  • The first step is to derive the relationship between the price or value of the asset in question and the influencing factors or variables, like its features and characteristics in terms of location, environment, etc.
  • The second phase or step is the willingness of the party involved to pay for the property.

In this case, the price variation in the property because of the influence of various factors or features is termed a hedonic price, which is nothing but the additional cost added to the property value due to the additional advantageous features or factors.

Examples

Below are the examples that show the significance of the hedonic pricing approach:

Example #1

The housing industry is the best example to understand the hedonic pricing model. The house’s value depends on the carpet area, number of rooms, location, builder, floor number, transportation, railway station, etc. These factors will weigh the house’s valuation since they are essential for any home buyer.

  • Location A: Established builder, two-bedroom house, nearby railway station, school, and 5 minutes from the highway.
  • Location B: It has a new builder. It is a two-bedroom house, 20 minutes from the railway station.

Solution:

In the above case, location A will be costlier than location B since the nearby railway station will impact the prices of both houses. Consumers will prefer location compared to location B since transport is easily available, providing flexibility. Since location B is a faraway place, the buyer would be ready to spend more since it will save his time daily to travel to the nearest railway station to come to the office.

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

Example #2

  • Location A: It is a two-bedroom house, a fully residential area, pollutants dumping yard 5 minutes away.
  • Location B:  It is a two-bedroom house. Fully residential.

Solution:

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

Advantages

Below mentioned are some of the major advantages of hedonic pricing: –

  • It focuses more on the customers’ consumption patterns and can price fairly.
  • It considers both internal and external factors that will affect the buyer’s decision-making.
  • Gives more preference to the likes and dislikes of the buyer to buy a house.
  • A 360-degree approach to price a particular product.

Disadvantages

  • It does not consider the information hidden from the house buyer to inflate the price. E.g., if there is a water problem in the locality despite being a good location, it may face opposition from buyers. Hence, by not disclosing the fact, the builder may keep the price intact of the house.
  • It sometimes does not consider 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.

Frequently Asked Questions (FAQs)

1. What is the composition of hedonic pricing models?

The composition of hedonic pricing models includes both internal and external factors that affect the price of a good or service. Internal factors refer to the inherent characteristics of the good or service, such as size, quality, and features. In contrast, external factors include market conditions, location, and other economic and demographic variables.

2. What are the applications of hedonic pricing?

Hedonic pricing has many applications, but it is particularly useful in the real estate industry for determining the price of homes and commercial properties. It can also determine the value of other goods and services, such as cars, consumer electronics, and healthcare services.

3. What is the hedonic pricing of cloud computing services?

The hedonic pricing of cloud computing services would involve considering the various attributes of the service, such as storage capacity, processing power, security features, and customer support, as well as market conditions and demand for cloud services. These factors would be used to determine the service’s fair value and set a competitive price that considers both the service’s features and its place in the market.

This article is a guide to what is Hedonic Pricing. Here we explain the model with examples, steps, advantages, and disadvantages. You may learn more about accounting from the following articles: –

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