Hedonic Evaluation Approach
The hedonic approach to economic assessment can be used for evaluating the economic value of environmental goods such as noise, air or water quality, landscape and similar goods.
The hedonic approach is based on the assumption that goods can be considered aggregates of different attributes, some of which, as they cannot be sold separately, do not have an individual price. On real estate markets for example, it is not possible to purchase separately the room, the preferred location, the panoramic qualities, quality of air or of surrounding landscape. It is one frequently applied methodology for the assessment of natural values based on market values.
The hedonic approach to evaluation attempts to estimate the economic value using implicit prices of single characteristics of a good on the basis of market values of the whole good. The use of this approach is of particular interest in the field of environmental valuation, as it can be assumed that the values attributed to natural resources are attributes of commodities which are sold on the market. Obviously, the more closely the market good is related to the use of a natural resource, the more suitable is this approach for the evaluation of the natural resource. Real estate properties are very interesting in this context, as their values are strongly influenced by locational characteristics.
The approach assumes that the economic value of each attribute influences the total value of the commodity and can thus be revealed as a difference in price, for instance real estate properties, assuming all other characteristics to remain constant. It is based on the identification of the part of value which regards the characteristic to be evaluated, and in case of variations of the characteristic, on the possibility of estimating its demand function. The theory at the basis of hedonic methods have been formulated by Rosen (1974) and successively improved with regards to the valuation of environmental goods by Freeman (1979). Rosen’s model simulates a competitive market and foresees the simultaneous estimation of demand and supply function. In the particular case of real estate markets, with a very rigid supply, the model can be simplified and traced back to the neoclassic scheme of the theory of consumer’s demand (Diamond and Smith). The correct application of the hedonic approach requires that the following hypothesis have been positively verified:
- the market must offer a continuous range of choices, that means, all combinations between private good and environmental conditions;
- purchasers must be able to behave according to the principle of decreasing marginal utility with respect to the environmental characteristics;
- purchasers must have the same opportunity of access to the market. In other words, they must have the same cost of information, transaction and transfer, the same income available and the same mobility;
- a perfect transparency of prices and characteristics must be given;
- prices must adapt immediately to changes in the demand for environmental goods.
These hypothesis are of course restrictive, as they describe a market which is perfectly transparent on the side of the offer, and, is homogeneous and perfectly competitive on the demand side.
On an operative level the approach proceeds in two phases:
- estimate the value function of the private good;
- estimate of the demand function of the environmental characteristics of the surplus.
The estimation of the function of the prices of private goods is generally obtained applying statistical methods of linear (or linearized) multiple regression: [math]V=\beta_0+\sum_i\cdot x_i+ \epsilon[/math]
In this way each single characteristic of the good is associated with a parameter ßi which represents, if the above conditions are satisfied, according to the specification of the variable, the implicit price. The hedonic approach shows, besides its doubtless advantages, some limits which add to the general one of respecting the hypothesis on the characteristics of real estate markets:
- it can be applied only in presence of a good number of market exchanges, as the model representing the market requires a certain number of good quality data;
- the market must be sufficiently transparent;
- the valuation might be biased if there are expectations with regards to changes in environmental qualities;
- It is not possible to estimate the total economic value of the environmental good, but only the value connected to present and, with some caution, future uses.
- Rosen, S. (1974). "Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition." Journal of Political Economy 82
- Freeman, A. M., III, (1979). "Hedonic Prices, Property Values and Measuring Environmental Benefits: A Survey of the Issues." Scandinavian Journal of Economics 81(2)
- Diamond, D. B. and B. A. Smith (1985). "Simultaneity in the Market for Housing Characteristics." Journal of Urban Economics 17(280-292)
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