Willingness to Pay in Hedonic Pricing Models

The value of a differentiated product is simply the sum of its parts. This concept is easily observed in housing markets where the price of a home is determined by the underlying bundle of attributes that define it and by the price households are willing to pay for each attribute. These prices are referred to as implicit prices because their value is indirectly revealed through the price of another product (typically a home) and are of interest as they reveal the value of goods, such as nearby public amenities, that would otherwise remain unknown. This concept was first formalized into a tractable theoretical framework by Rosen, and is known as the hedonic pricing method. The two-stage hedonic method requires the researcher to map housing attributes into housing price using an equilibrium price function. Information recovered from the first stage is then used to recover inverse demand functions for nonmarket goods in the second stage, which are required for nonmarginal welfare evaluation. Researchers have rarely implemented the second stage, however, due to limited data availability, specification concerns, and the inability to correct for simultaneity bias between price and quality. As policies increasingly seek to deliver large, nonmarginal changes in public goods, the need to estimate the hedonic second stage is becoming more poignant. Greater effort therefore needs to be made to establish a set of best practices within the second stage, many of which can be developed using methods established in the extensive first-stage literature.