Wednesday, 26 May 2010

HIPerbolic discounting

Latest in my series of bad puns on the word "hyperbolic".

HIPs are being scrapped by the new government. This will provide relief to millions of annoyed estate agents ad house sellers everywhere. But why?

HIPs should be a gift from the economics profession which is joyfully accepted by buyers, sellers and agents. The reason? Because houses are a classic "market for lemons".

A simple explanation of what this means and what the consequences are: The seller of a house knows much more about it than the buyer. Therefore, if the seller thinks it is worth £200,000, a buyer should apply a discount to take account of the risk that something is wrong. Let's say they apply a 10% discount and offer £180,000. After the discount, some sellers who do not have anything wrong with their house will prefer to stay rather than sell for less than it's worth. Other sellers, who do have a skeleton in the cupboard, will keep their house on the market. The average quality of the available houses declines. Therefore, buyers look at this situation and decide to apply a larger discount. They adjust their bids down even further, even more sellers withdraw, and so on. The market enters a death spiral.

To combat this problem, buyers would traditionally commission a survey of the property to make sure it is sound. Sensible, but expensive. A structural survey costs perhaps £700, and only after it is complete would the buyer decide whether to bid on the property. Even if they do bid, they might still not win. So a conscientious buyer might end up paying for three or four surveys before successfully acquiring a house. This adds a big risk - and transaction cost - to the process of buying, and must reduce the number of available bidders for each property.

HIPs were designed to solve this problem. Instead of multiple buyers commissioning a survey, the seller would do it once. Only one surveyor would be needed instead of several. And each buyer would know, in advance, the state of the property and could decide whether to bid without incurring a entry cost to do so.

Beautifully logical. It doesn't even impose any net cost on the seller, because they can simply factor the cost of the report into their asking price. And it must surely increase the number of bidders on each property, which would increase the sale price achieved. So why did sellers and estate agents scream blue murder as soon as the subject was raised?

First, the superficial claims:

  1. The buyer won't trust the report anyway, because it was commissioned by the seller. Only true if the seller does not use a respected firm of surveyors. There are plenty of big surveyor firms which have enough financial strength to be sued by a buyer if the survey turns out to be false. And there are plenty of insurance companies willing to participate in this market if people don't think the surveyor will have enough money.
  2. The buyer can't sue the surveyor, because the surveyor's client is the seller. Do these people really think it's beyond the wit of the UK's legal profession to design a contract structure which transfers this responsibility? This is a nation with more property lawyers per capita than any other in the world.
  3. The HIP is no use because it doesn't include a structural survey. True, but only because the estate agents lobbied for it not to! The original proposal was to make the structural survey mandatory. So shall we go back to that instead of dropping the scheme altogether?
None of those reasons are convincing. Why then do people really dislike this idea so much?

There are a few different reasons for these objections. (The presence of multiple causes is an interesting theme, which I'll analyse in a posting soon).

  1. Hyperbolic discounting. Although there are direct benefits to the seller in commissioning their own survey, the benefits come later - after the house is sold - while the cost comes up front. Therefore the cost gets much more weight.
  2. Availability heuristic. Even though sellers know, when they think it through, that they will gain from the scheme, the benefits are never directly visible to them. No seller will ever know that they achieved a price of £208,000 when they would otherwise have only got £202,000. They have to rely on economic theory to tell them. But that £700 is coming out of their pockets right now and is painfully concrete.
  3. Slippery slope. This episode reveals something that most lay people do not know. Selling a house is, often, a surprisingly impulsive decision. People will walk into an estate agent off the street and ask for a valuation "just out of curiosity". The estate agent knows this very well, and knows that once the valuation is done, they are more than halfway to persuading the homeowner to put the house on the market. Each step is a small one, and anything - like a £700 outlay - which might interrupt this process will put a damper on the market.
  4. Badly designed agency incentives. Estate agents are primarily rewarded just for selling a house. In fact, though, it's incredibly easy to sell a house. Just put your £200,000 property on the market for £150,000 - it will be gone in no time. The difficult part is getting someone to pay £220,000 for a £200,000 house. So really, that's what the agent should be paid for doing. Instead of charging 1.5% of the purchase price, they should be paid nothing for achieving the first 80% of the valuation, 5% of the gap between that and the valuation, and 10% of anything above the expected value. That would encourage the agent to actually care about the value the seller achieves, and not just to pump through as many transactions at as high a speed as possible. From the buyer's point of view, they want to find a property offering the maximum consumer surplus - the biggest gap between purchase price and happiness obtained. I'm not sure how to reward an agent for that, but a loyalty bonus based on how long the buyer stays in the house might be a good mechanism.

    All of this means that estate agents have different incentives to sellers, and made it their business to persuade sellers that this would kill the market. There is a grain of truth in that claim, because of item 3 in this list, but agents, in this campaign, are primarily serving their own interests and not that of their customers.
All of these things combine to make the market fail. And together, they have killed a proposal which is an economic no-brainer - a policy which would reduce waste, and help buyers and sellers to get what they both want at the right price.

Cognitive biases suck, don't they?


John said...

good knowledge thanks.

Frank said...

I agree with all that, nicely put.