Hedonics: Violating the Laws of Physics

Tuesday, December 16, 2014

Many are probably familiar with the proverb "What goes up must come down." Throw an apple up in the air, and one does not have to wait long to see it fall down.

While physics has demonstrated to us that things must first go up before they come down, the world of economics plays by its own rules. When dealing with economics, prices can both rise and fall at the same time. Does this sound bizarre to you? Welcome to the wonderful world of hedonic price adjustments.

Let's take a very simple example: an automobile.

The Ford Model T was released in 1908 for a mere $240. It was a great buy in its day.

hedonic pricing
Image courtesy of Lars-Goran Lindgren Sweden

Now let's take a look at the modern-day Toyota Corolla - today's vehicle for the everyday man. Its sticker price is just under $17,000.

So here's a question: which car was cheaper when it was being sold? The Model T for $240 or the Corolla for $17,000?

Before you shout out "The Model T," think about the following. Which one has better safety features? If you were to get into a high speed car crash with a Model T, you'd probably die. A Toyota Corolla? The modern airbags and crumple zones would probably ensure that you'd be able to walk away, and live to tell the tale.

It turns out that a Corolla and Model T are so different, we can't compare their prices directly. It would be like comparing apples and oranges. To make the comparison more fair, we have to adjust the prices to reflect the fact that the Corolla features many advancements that were never in the Model T. This adjustment is called a hedonic adjustment.

We might say, for instance, that the safety features on a modern Corolla are worth $6,000. So we're not really comparing a $17,000 Corolla to a $240 Model T. We're really comparing an $11,000 Corolla to a $240 Model T. In fact, the Corolla probably has many other great features that were missing from the Model T. We could adjust for the stereo system, the power steering, the longer lifespan of the drivetrain, the color options and so on. Before you knew it we could adjust the price of a modern day car down to match the price of Model T. We might even be able to adjust the Corolla's price down below the Model T's by quite a bit.

How can a price go up and down at the same time? Behold the power of economics! But how did we know that the safety features were worth $6,000 and not $2,000 or $15,000? Behold the power of economists! Hedonics allows for a significant "fudge factor" that provides significant discretion to the economist performing the adjustments.

While the value of a good can go up and down, the value of my book on pricing software will only help your bank account increase. Grab a copy today! Or just contact me for a pricing consultation.