This past summer I read Freakonomics, which is a book that combines Economics and pop-culture written by Steven Levitt and Stephen Dubner. It looks at different economic problems that “traditional” economists wouldn’t cover but that people around the world are very intrigued about.
When we covered the topic of bargaining power in class I remembered one of the great chapters that I read in the book on the “How is the Ku Klux Klan Like a Group of Real-Estate Agents?” The chapter highlights the similarity between how the KKK derived power by having a massive control over information to how real estate agents have a great power in selling a house due to the exclusive information that they have.
Pictured above is the world’s most expensive home, valued at about $1 billion dollars it is located in Mumbai and owned by Mukesh Ambani.
When people sell houses they usually approach a real estate agent, who after having visited the house and analysed the housing market comes up with a price that is the most beneficial to the seller. He or she then carries out aggressive marketing and showcases the house to many buyers, until the house is sold and the sellers are happy. Real estate agents are then rewarded greatly for this work, as they earn commissions ranging from 5 to 10 percent of the final selling price. The million dollar question is if the real estate agents are indeed incentivized to find you the best deal or not, and this blog post will explain why unfortunately they are not incentivized to do so using the arguments in Freakonomics.
In economics there is a concept known as information asymmetry, which is when one party has a greater information power than another. This is why consumers often pay experts for help, for example doctors to carry out operations or lawyers to carry out lawsuits, all is because the consumer knows that the other party has better information. It therefore comes with no surprise that these people with greater information might use this to their own personal advantage. For example, there have been many cases of doctors convincing their patients to undergo expensive operations that have no health benefit and yet provide doctors with great profits. Freakonomics argues that real estate agents are a perfect way to analyze how “experts” treat other people since public records are available of all houses that have been sold and it is then possible to see the difference in how a real estate agent sold his/her own house and how they sold their customers house.
Levitt and Dubner analyzed over 100,000 Chicago homes, and controlled for several variables such as the location, aesthetics, etc. of the houses, since this was all available in public records. They were then able to find the result that real estate agents end up selling their houses for 3% more and keep them on the market for almost ten more days than their customers houses. This might seem like trivial numbers but 3% on a house worth $500,000 is $15,000 which is a fair amount of money.
Mathematically the reason why the agent doesn’t push for higher prices makes a lot of sense. In the case of the 3% increase in price value of a $500,000 home, the agent would increase his or her earnings by 750 dollars while requiring a lot of more work and dedication to the project.
The real estate agent’s goal is thus to use his or her power to convince the home sellers to sell at a lower price and at the same time to hint to the buyers that the house can be bought cheaply, so that the house can be sold quicker. Here is where the Freakonomics authors took another insightful approach by analyzing the difference in words used by real estate agents in the ads for their own houses vs. the houses of their customers. Real estate agents often used words such as “granite”, “state-of-the-art”, etc. to give physical descriptions of their own homes and advocate for the true worth of the house. For their customers they would often say “charming”, “wonderful” and “fantastic” which are filler adjectives with no true meaning, or they would write “great neighborhood” hinting to the fact that the house wasn’t nice but at least the houses close-by were great.
The above photograph of a house would in many cases be described by real estate agents as “charming” and “great neighborhood” in case it was their customers’ but they might opt for other words, such as “granite” in case it was their own.
It is although important to note that a lot has gradually changed from the time Freakonomics was written in 2005 until now. In todays world the growth of the Internet has provided consumers with a lot of information so that real estate agents have lost a lot of the lucrative information that they had control over before. A real estate agent today can’t tell you that the market is in a dip when it actually isn’t, since you have all that information available online on websites such as realtor.com and domania.com. It therefore comes with no surprise that the difference in price between real estate agents’ houses and their customers’ houses is getting smaller and smaller.
If you would like to read more of Freakonomics, you can find it at the Stanford library:
Levitt, Steven D., and Stephen J. Dubner. Freakonomics: A Rogue Economist Explores the Hidden Side of Everything. New York: William Morrow, 2005. Print.