A Rational Expectations Approach to Hedonic Price Regressions with Time-Varying Unobserved Product Attributes: The Price of Pollution

Abstract

We propose a new strategy for a pervasive problem in the hedonics literature: recovering hedonic prices in the presence of time-varying correlated unobservables. Our approach relies on an assumption about home buyer rationality, under which prior sales prices can be used to control for time-varying unobservable attributes of the house or neighborhood. Using housing transactions data from California's Bay Area between 1990 and 2006, we apply our estimator to recover marginal willingness to pay for reductions in three of the EPA's “criteria” air pollutants. Our findings suggest that ignoring bias from time-varying correlated unobservables considerably understates the benefits of a pollution reduction policy. (JEL D12, D84, Q53, Q58, R21)

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“…Our measure of neighborhood condition is based upon hedonic price theory applied to residential housing markets. 29–32 Hedonic price theory explains how a home’s price can be decomposed into individual prices for each of the varied characteristics of the home (e.g., number of bedrooms, existence of central air, type of foundation, school district, etc), including neighborhood condition. 32,33 We used this theory to develop our measure of neighborhood condition.…”

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“…To address this issue, we adopt a hedonic regression approach, following Bajari et al [4]. By explicitly modeling the evolution of time-varying unobservable factor and estimating the model with GMM (Generalized Method of Moments), we can deal with a time-varying omitted variable (daily sales variable in our case) that is potentially correlated with daily online buzz.…”