Environmental Valuation - Hedonic Pricing

18/02/09 Carlos Ferreira 1

Environmental Valuation

Hedonic Pricing Method


Revealed Preference● Goods are composed by a bundle of attributes● Consumer utility results from the combination of

all attributes of the good...

● Consumer's WTP is a function of those attributes

● We should be able to model WTP for a particular good as a function of the levels of each attribute


Determining the implicit price of the environmental good

1.Choose a market-priced good whose price is influenced, among other things, by the environmental good/liability.

2.Measure, as accurately as possible, the quantity of the all characteristics that determine the price of the good (including the environmental good)

3.Regress the Utility function

NOTE:ΔU ≈ WTP


Markets used● Housing (property)● Housing (renting)● Wages● Rationale: there's an implicit value to environmental

amenities, which impacts market prices- Individuals are WTP more for a house in a location where env. amenities are better, ceteris paribus.- Individuals are WTA working in environmentally risky/unpleasant conditions for higher wages, ceteris paribus.


Utility Function: Housing Property Market

P = f (H1, …, H

m; N

1, …, N

n; A

1, …, A

p)

H = housing characteristics

N = neighbourhood characteristics

A = environmental characteristics

U = f (H, N, A), subject to I = PG.G + P

H.H

G = Other Goods the subject consumes

Considering the Housing Market is in equilibrium, PWTP

= PWTA

, and utility constant (at W*), we obtain the house price acceptance function:

PWTP

= f (U*, I, A, PG)

Differentiating with respect to the specific environmental amenity (A) and maintaining utility constant at U, we obtain the willingness to pay for improvement in A.


Problems with the model● Assumes equilibrium in the relevant market● Omitted variable bias● Error of measurement bias● Multicollinearity● Heteroscedasticity● No specified Functional Form● Market segmentation● Expected versus actual characteristic levels● Attitudes to risk


Example

Hedonic Valuation of Marginal Willingness to Pay for Air Quality in Metropolitan Damascus


Objectives

1. Estimate the MWTP for air quality improvement in Damascus;- high levels of Total Suspended Particulate (TSP)

2. Test the validity of applying the HP method in Damascus- high variation in pollution in different areas- only two types of common housing- developing country


Market Scope

● Traditional housing (rarer, more expensive, seldom transacted) excluded from the analysis

● Two small districts (elite, exceptionally expensive) excluded from the analysis

● Used two kinds of property value: price of the house (stock variable) and rent of the house (flow variable)


Data Issues● Data on property values not readily available● Need to interview residents to obtain property

values, incomes and structural quality● “Expert advice” by local real estate agencies● TSP values are the average of the minimum

and maximum concentration read in late Summer 2000.

● Data on neighbourhood location and accessibility directly observed


Functional Form and Variablesln(PRICE) = ln(AREA) + ln(ROOM) + ln(FLRLEV) + HQSTR + LQSTR + LIGHT + DNBR +

+ LHMG + ln(HEALTH) + ln(CENTER) + ln(INCOME) + ln(TSP)

Functional form chosen for● Simplicity● Highest adj. R2 (0.85)● Signs and magnitudes of coefficients conform to expectations


Results● The Marginal WTP for a unit-decrease in TSP is

approximately $60.00● The author considers such value “reasonable”● The study has demonstrated the feasibility of

using the HP method in the context of developing countries.

However, for all its strengths we believe thestudy deserves a further critical appreciation


Criticisms● Variables Used

- Price: mixing property and rental markets- TSP: usage of min-max average values; data pre-dates study by some years; other types of pollution ignored – valuable proxy?- Structural quality: obtained through home-owners and realtor's descriptions

● Criteria for choosing Functional Form is somewhat loose


In conclusion● HP method is deceptively simple● A sturdy theoretical approach● Various practical considerations

- Variables used- Functional Forms

● Results very sensitive to inefficiencies in the market considered

● Better at evaluating the effect of policies ex-post than at predicting them

● Presently, the scope for usage seems somewhat limited


References● Alsherfawi A., M. (2005). Hedonic Valuation of Marginal Willingness

to Pay for Air Quality in Metropolitan Damascus. Forum of International Development Studies, no. 30: 23 – 34.

● Garrod, G & Willis, K. G. (1999). Economic Valuation of the Environment. Cheltenham: Edward Elgar.

● Hanley, N., Shogren, J. F. & White, B. (2007). Environmental Economics in Theory and Practice. Hempshire: Palgrave Macmillan.

Environmental Valuation - Hedonic Pricing

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