Hedonic regression

Last updated August 20, 2023

In economics, hedonic regression, also sometimes called hedonic demand theory, is a revealed preference method for estimating demand or value. It decomposes the item being researched into its constituent characteristics, and obtains estimates of the contributory value for each. This requires that the composite good (the item being researched and valued) can be reduced to its constituent parts and that those resulting parts are in some way valued by the market. Hedonic models are most commonly estimated using regression analysis, although some more generalized models such as sales adjustment grids are special cases which do not.

Hedonic models are commonly used in real estate appraisal, real estate economics and Consumer Price Index (CPI) calculations. In CPI calculations, hedonic regression is used to control the effect of changes in product quality. Price changes that are due to substitution effects are subject to hedonic quality adjustments.

Hedonic models and real estate valuation

In real estate economics, Hedonic regression is used to adjust for the issues associated with researching a good that is as heterogeneous, such as buildings. Because individual buildings are so different, it is difficult to estimate the demand for buildings generically. Instead, it is assumed that a house can be decomposed into characteristics such as its amount of bedrooms, the size of its lot, or its distance from the city center. A hedonic regression equation treats these attributes (or bundles of attributes) separately, and estimates prices (in the case of an additive model) or elasticity (in the case of a log model) for each of them. This information can be used to construct a price index that can be used to compare the price of housing in different cities or to do time series analysis. As with CPI calculations, Hedonic pricing can be used to:

Correct for quality changes in constructing a housing price index.
Assess the value of a property, in the absence of specific market transaction data.
To analyze the demand for various housing characteristics, as well as housing demand in general.

Due to the macro-oriented nature of hedonic models, with regard to their more general approach to assessment when compared to the more exacting and specific (albeit less contextualized) approach of individual assessment, when used for mass appraisal, the Uniform Standards of Professional Appraisal Practice, or USPAP, has established mass appraisal standards to govern the use of hedonic regressions and other automated valuation models when used for real estate appraisal.^[1]

Hedonic models outside of real estate valuation.

Aside from its use in housing market estimations, Hedonic regression has also seen use as a means for testing assumptions in spatial economics, and is commonly applied to operations in tax assessment, litigation, academic studies, and other mass appraisal projects.

Appraisal methodology more or less treats hedonic regression as a more statistically robust form of the sales comparison approach,^[2] making it a popular means for assessment in any market or economic sector in which valuation between two categorically similar (or same) goods (such as two different kitchenware sets) can differ greatly based on additional factors (such as whether the pots and pans made of copper, cast iron, stone, etc, or what non-stick coating, if any, was applied) or constituent goods (including a steamer basket for one of the pots or having the largest pot be a Dutch oven) that strongly influence or semi-exclusively determine the unified good's value.

History

Hedonic modeling was first published in the 1920s as a method for valuing the demand and the price of farm land. However, the history of hedonic regression traces its roots to Church (1939),^[3] which was an analysis of automobile prices and automobile features.^[4] Hedonic regression is presently used for creating the Consumer Price Index (CPI).^[5]

Criticisms of hedonic models

Some commentators, including Austrian economists, have criticized the US government's use of hedonic regression in computing its CPI, fearing it can be used to mask the "true" inflation rate and thus lower the interest it must pay on Treasury Inflation-Protected Securities (TIPS) and Social Security cost of living adjustments.^[6]

The same use of hedonic models when analyzing consumer prices in other countries, however, has shown that non-hedonic methods may themselves misstate inflation over time by failing to take quality changes into account.^[7]

Related Research Articles

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A consumer price index (CPI) is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time. The CPI is calculated by using a representative basket of goods and services. The basket is updated periodically to reflect changes in consumer spending habits. The prices of the goods and services in the basket are collected monthly from a sample of retail and service establishments. The prices are then adjusted for changes in quality or features. Changes in the CPI can be used to track inflation over time and to compare inflation rates between different countries. The CPI is not a perfect measure of inflation or the cost of living, but it is a useful tool for tracking these economic indicators.

<span class="mw-page-title-main">Valuation (finance)</span> Process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.

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The sales comparison approach (SCA) relies on the assumption that a matrix of attributes or significant features of a property drive its value. For examples, in the case of a single family residence, such attributes might be floor area, views, location, number of bathrooms, lot size, age of the property and condition of property.

The following outline is provided as an overview of and topical guide to finance:

The United States Consumer Price Index (CPI) is a set of various consumer price indices published monthly by the U.S. Bureau of Labor Statistics (BLS). The most commonly used are the CPI-U and the CPI-W, though many alternative versions exist. The CPI-U is the most popular measure of consumer inflation in the United States.

A house price index (HPI) measures the price changes of residential housing as a percentage change from some specific start date. Methodologies commonly used to calculate an HPI are hedonic regression (HR), simple moving average (SMA), and repeat-sales regression (RSR).

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An Automated Valuation Model (AVM) is a system for the valuation of real estate that provides a value of a specified property at a specified date, using mathematical modelling techniques in an automated manner. AVMs are Statistical Valuation Methods and divide into Comparables Based AVMs and Hedonic Models. Other Statistical Valuation Methods are House Price Indices and Single Parameter Valuations.

A hedonic index is any price index which uses information from hedonic regression, which describes how product price could be explained by the product's characteristics. Hedonic price indexes have proved to be very useful when applied to calculate price indices for information and communication products and housing, because they can successfully mitigate problems such as those that arise from there being new goods to consider and from rapid changes of quality.

References

↑ Hedonic Regression Models Ben J. Sopranzetti Rutgers, The State University of New Jersey Article · August 2015 DOI: 10.1007/978-1-4614-7750-1_78
↑ John A. Kilpatrick, Real Estate Issues in Class Certification Archived 2007-10-10 at the Wayback Machine
↑ A. T. Court, Hedonic price indexes with automotive examples, in ‘‘The Dynamics of Automobile Demand,’’ General Motors, New York, pp. 98]119 1939 .
↑ "Andrew Court and the Invention of Hedonic Price Analysis" (PDF).
↑ Hedonic Regression Models Article · August 2015 Ben J. Sopranzetti Rutgers, The State University of New Jersey DOI: 10.1007/978-1-4614-7750-1_78
↑ See, for example, Lippe, Peter von der (2001). "Some Conservative Comments on Hedonic Methods" (PDF).
↑ See, for example, Reis, Hugo J.; Silva, J. M. C. Santos (2006). "Hedonic Price Indexes for New Passenger Cars in Portugal (1997–2003)" (PDF). Economic Modelling. 23 (6): 890–906. doi:10.1016/j.econmod.2006.04.003.