Opinion and Economic Analysis and Economy and Economic Development

HICKS: Non-market valuation is an important planning tool

October 24, 2009

One of the more intriguing things economists are called upon to do is what is known as non-market valuation. This is a process for estimating a “price” of something that isn’t typically bought or sold.

There are two ways to do this. One involves mimicking a psychological experiment on lots of people. This is a costly endeavor and the methodology still suffers considerable opposition.

The second method uses existing data on observed human behavior to “back out” the price of some unobserved item. This technique also has the relatively cool name (for economists) of Hedonic Pricing. It is taken from the Greek word for delight, and has become a widely used tool in the courts, regulatory agencies and among real estate appraisers (who use modern methods).

My favorite example involves measuring the effect of “airport noise” on the price of a home. An enterprising researcher could gather thousands of home-sales records from around the region. Each record would contain dozens of specific pieces of information about the home: size, construction date and material, the quality of schools, number of rooms, basement and lot size, etc.

To each one of these records we could also add the distance of the home to the nearest airport runway. We then use a statistical technique that virtually all 21-year-olds with a decent college major know and we can isolate the role distance to an airport plays in the price of a home. The tool is fantastic because it lets us control for all other important features of the house that might be at play.

Economists have used this tool to estimate all kinds of important relationships in addition to proximity to an airport. We know what happens to home values when there’s a toxic release nearby, how home values vary with school quality, the effect of being near a Wal-Mart, and even the implications for home values of moving a registered sex offender into the neighborhood.

Why does knowing this matter? Of course, the knowing of something may have its own value (even if there’s no price on it). This technique tells us specifically what the price would be. For example, if you live near a toxic spill, the courts now have a way to assess damages to the company that spills the chemicals. The implications go beyond litigation to planning of public infrastructure. Construction of roadways and airports will affect commercial and residential property values outside the construction zone, so should be considered when locating or expanding infrastructure. The technique also tells us what to build.

The city of Muncie recently spent several million dollars to extend a walking and biking trail to the west side of town. This was a wise expenditure. Several studies (including mine) on the effect of these trails on home values have found that homes near the trails see average values rise $9,000 to $11,000. Except for education, that is a higher market effect per dollar invested than any other public expenditure.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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