Question

Explain the hedonic pricing model of job risk. As part of your discussion, explain the shape of workers' indifference curves, isoprofit curves, and the hedonic wage function.

Answer 1

Hedonic pricing is a model, which identifies price factors, according to the premise that price is determined both by internal characteristics of the good being sold and external factors affecting it.

A hedonic pricing model is often used to estimate quantitative values for ecosystem or environmental services that directly impact market prices for homes. This method of valuation can require a strong degree of statistical expertise and model specification, following a period of data collection.

•Workers care about whether their job is safe or risky.
•Utility = f(wage, risk of injury).
•Indifference curves reveal the worker’s preferences between wages and risk.
•
•Firms may have a risky work environment

because it is less expensive to pay higher wages

than to make the environment safe.

or

Assume only two types of jobs in the labour market (safe jobs versus risky jobs). - Safe jobs have probability of zero that worker gets injured. Risky jobs have probability of 1! Workers know this. • Workers care about whether their jobs are safe or risky. • A worker’s utility function: Utility = f (w, risk of injury) • Indifference curves reveal the trade-offs that a worker prefers between wages and degree of risk (risk assumed to be a ‘bad’): To provide the same utility, risky jobs must pay higher wages than safe jobs.

The most common example of the hedonic pricing method is in the housing market, where the price of a building or piece of land is determined by the characteristics of the property itself (e.g. its size; appearance; specific features; such as solar panels or state-of-the-art faucet fixtures; and its condition), as well as characteristics of its surrounding environment (e.g. if the neighborhood has a high crime rate and/or is accessible to schools and a downtown area; the level of water and air pollution, the value of other homes close by, etc.) The hedonic pricing model is used to estimate the extent to which each factor affects the price of the home. When running the model, if non-environmental factors are controlled for (held steady), any remaining discrepancies in price will represent differences in the good’s external surroundings.

With regards to valuing properties, a hedonic pricing model is relatively straightforward as relies on actual market prices and comprehensive, available data sets.

The hedonic pricing model has many advantages, including the ability to estimate values, based on concrete choices, particularly when applied to property markets with readily available, accurate data. At the same time the method is flexible enough to be adapted to relationships among other market goods and external factors.

Hedonic pricing also has significant drawbacks, including its ability to only capture consumers’ willingness to pay for what they perceive are environmental differences and their resulting consequences. For example, if potential buyers are not aware of a contaminated water supply or impending early morning construction next door, the price of the property in question will not change accordingly.

Hedonic pricing also does not always incorporate external factors or regulations, such as taxes and interest rates, which could also have a significant impact on prices.

An indifference curve represents a series of combinations between two different economic goods, between which an individual would be theoretically indifferent regardless of which combination he received.

Indifference curves are heuristic devices used in contemporary microeconomics to demonstrate consumer preference and the limitations of a budget. Later economists adopted the principles of indifference curves in the study of welfare economics.

For example, a young boy might be indifferent between possessing two comic books and one toy truck, or four toy trucks and one comic book.

Standard indifference curve analysis operates on a simple two-dimensional graph. One kind of economic good is placed on each axis. Indifference curves are drawn based on the consumer's presumed indifference. If more resources become available, or if the consumer's income rises, higher indifference curves are possible – or curves that are farther away from the origin.

As an example, consider the diagram above. According to this model, this consumer would be most satisfied with any combination of products along curve U3. The consumer would be indifferent between combination (Qa1, Qb1) and (Qa2, Qb2). A series of indifference curves is sometimes called an indifference curve map.

Many core principles of microeconomics appear in indifference curve analysis, including individual choice, marginal utility theory, income and substitution effects, and the subjective theory of value. The study of marginal rates of substitution and opportunity costs are emphasized. All other economic variables and possible complications are treated as stable or ignored unless placed on the indifference graph.

Isoprofit curves

A curve showing the combinations of two or more variables that generate the same level of profit for a firm.

combination of wages and fringe benefits that yield the same level of output

slope shows the price to the firm of providing fringe benefits

constraint of wage differential model...upward sloping but gets flatter as bad increases

Higher isoprofit curves yield lower profits.

Properties of isoprofit curves
1. upward sloping (costs money to produce safety
2. higher isoprofit curves = lower profits
3. Concave

A Hedonic wage function reflect the relationship between wages and job characteristics. It matches workers with different risk preferences with firms that can provide jobs that match these different risk preferences. Or The observed relationship between wages and job characteristics is called a hedonic wage function.

Different firms have different isoprofit curves and different workers have different indifference curves.The labor market marries workers who dislike risk with firms that find it easy to provide a safe environment and workers who do not mind risk very much with firms that find it difficult to provide a safe environment.