One of the biggest pricing decisions most people make is usually outsourced. When selling a home, most of us rely on real estate agents to set the price for us and guide us in negotiating with buyers. Certainly, the average real estate agent knows a lot more about the housing market than the average person. Since they are working for us, and receive a commission based on the final price of the home, the agent’s incentive is to get us the best price possible, right?
Wrong, says Steven D. Levitt, winner of the John Bates Clarke Medal for the best American economist under 40 years of age. In Freakonomics, an interesting look at the impact of incentives (whose most controversial claim is that the biggest factor in the decrease in the crime rate was Roe v. Wade), Levitt examines how well a real estate agent represent your pricing interests. Levitt and examines real estate transactions to see if agents behave differently when selling clients’ home versus their own homes.
But as incentives go, commissions are tricky. First of all, a 6 percent real-estate commission is typicaly split between the seller’s agent and the buyer’s. Each agent then kicks back half of her take to the agency. Which means that only 1.5 percent of the purchase price goes directly into your agent’s pocket.
So on the sale of your $300,000 house, her personal take of the $18,000 comission is $4,500. Still not bad, you say. But what if the house was actually worth more than $300,000? What if, with a little more effort and patience and a few more newspaper ads, she could have sold it for $310,000? After the commission, that puts an additional $9,400 in your pocket. But the agent’s additional share– her 1.5 percent of the extra $10,000– is a mere $150. … Maybe your incentives aren’t aligned after all. … Is the agent willing to put out all that extra time, money, and energy for just $150?
There’s one way to find out: measure the difference between the sales data for houses that belong to real-estate agents themselves and the houses they sold on behalf of client. Using the data from the sales of those 10,000 Chicago homes, and controlling for any number of variables– location, age and quality of the house, aesthetics, and so on– it turns out that a real-estate agent keeps her own home on the market an average of ten days longer and sells it for an extra 3-plus percent, or $10,000 on a $300,000 house.
What should we make of this (assuming we accept the findings)? First, it would seem we would want to pay our real estate agents differently. What if, instead of paying 6% commissions, we paid 3% up to a formula-driven valuation of the home, then 25% for every dollar beyond that? There are endless variations of this concept, but the central idea is that selling a home for market price is a less valuable service than selling the home for an above-market price. Really good real-estate agents should actually be happy about this, since they could make substantially more in commissions. (You’d have to tweak the parameters appropriately, of course. These parameters would net the agent $4750 vs $4650 on a $310,000 sale, but only $2250 vs $4500 on a $300,000. You might want to make it a bit more generous.) Next, think about this article, where a real estate agent discourages high prices, with some quite plausible arguments.
Finally, think about how your company sets prices, including list prices, discount types and amounts, and deal management guidelines. Do your incentives serve to maximize profit or other strategic goals? Or to price quickly? To maximize revenue?