Question

Question 2: Hedonic Modeling (5 points total) Assume we have two identical houses. Each house is a 3 bedroom, 3 bath, 2000 square feet white house on a 1 acre lot and both were built in 1996. The single difference is that house B is located near a beautiful hiking trail and house A is not. a) If both homes are listed for a price of $200,000, explain what will happen to the prices of these houses before the market reaches equilibrium. (1 point)

Answer 1

a) Equilibrium will only be reached if demand matches supply, house B has a beautiful hiking trail close by, and people would opt for this house, which will make the demand increase and price of this house will start to increase before it reaches equilibrium price level, price of house A will start reducing as demand for it will slow down as compared to house B.

b) House B is now more expensive as it has a beautiful view in addition to the amenities which house A has.

c) Difference in the value of the houses represents the price the customer is willing to pay for the proximity of an additional amenity i.e trail which he considers is worth spending money on.

d) Compensating differential is the additional amount a person is willing to pay for house B as compared to house A. The trail becomes the motivating factor for a person to pay the additional amount. The real estate agent is also willing to sell the house at a higher price and willing to sell house A at a lower price for the customers who are increasingly finding house B attractive and not house A.