Question

There are 4 ways of finding out how much people are WTP for improvements in environmental quality. One of them is “Hedonic estimation”. Explain this method by using an example?

Answer 1

The 'Hedonic estimation' approach is used to measure the people's willingness to pay for environmental improvements. Since environmental improvement is a public good and people's willingness to pay for such improvement is generally private information which is hard to get.

The best example to understand this hedonic approach can be the prices of houses in housing market. The price of houses are based on price of land it is build on, size of land, supply of water and electricity, and state of the art built facilities plus the environment around which it is build.

Now let's suppose, we can measure environment conditions thought numbering. Where low number means low quality environment which can be due to a factory operating which emits smoke in environment near the house and higher number indicating a better environment, this can be due to public park near the house.

So the best way to measure peoples willingness to pay for environmental improvements is to measure prices of housing when we move from a location where environment condition is ranked higher lower and then compare the housing prices where the environment condition is ranked higher. Note that while comparing the environment condition we must compare the same house, in respect of its size and facilities it provides. Then only we will be able to pin down exact willingness to pay for environmental improvements since both the houses will be the same, the price difference must arise from the fact that environment condition is not same.

Mathematically we can run a regression, in which we can run prices of housing on features of which we can denote by Xi (Xi vector of features of house) like its size, state of the art built facilities, supply of water and electricity, condition of law and order near the location. Plus we can have another explanatory variable, that is quality of environment near the house which we already discussed and let's denote it by Yi.

The general regression will look like as following,

Pi = BoXio + B1Xi1 + B2Xi2 + B3Xi3 + B4iY

Here the coefficient of Yi will that is B4, while keeping all other variables constant will measure the change in prices of housing due to change in the quality of environment near the house and we can have an estimate of people's willingness to pay for environmental improvements. That is how much people are willing to pay extra in order to move from a house which have an environmental rating of say 3 to 4. Here of course higher number indicates better quality of environment as discussed earlier.