A Fun Read for the Whole Family

We bought a house a few years ago. It was our first entry into the real estate market and it was quite scary. Most houses in Sydney are sold by auction, and this seemed to be a way to coax buyers into paying more than they could afford. We saw a house that my wife really wanted, and while talking to the sellers’ agent she blurted out the maximum price we would be willing to pay for it. We had sort of resigned ourselves to paying that much, but when the auction came around, we got the house for $10,000 less than that. That was my bid in the auction, and nobody was willing to bid more, so the auction price was less than the highest price we were willing to pay.

There is an explanation for what happened—while $10,000 is a lot of money for the seller, the real estate agent’s cut of this is quite small, so it is in his interest to work towards a quick sale, rather than getting the best price for the seller. Well, that is an explanation, but is it true? Steven Levitt came up with a clever way to test the explanation. He analyzed what happened when real estate agents sold their own homes as compared with regular folks and found that real estate agents took ten extra days to sell their own homes and got 3% more for them. His research is full of clever insights like this and now he has teamed up with Stephen Dubner to write Freakonomics a book giving a popular account of some of the things he has found out in his work. It was a very interesting and easy read. As I was reading it I left it in the living room while I did a few things and when I got back it had vanished because my 16-year-old had grabbed it and started reading it. He read the whole book after I had finished. His comment: “Very fascinating book”, and he passed it on to the 12-year-old, who said it was an “Amazing genius book”. Both boys told Mrs Lambert that she had to read it. She also enjoyed it, telling me “Almost makes me believe in statistics again”. So the unanimous opinion of my family is that it is a great book full of ideas that spark your interest.

The marketing campaign for Freakonomics uses blogs, with review copies sent out to several economist bloggers and, um, me. Levitt and Dubner have also started a blog about the book.

Of particular interest to this blog is the discussion on John Lott in the chapter examining the reasons for the crime drop in America in the 90s. Levitt describes Lott’s dishonest use of his Mary Rosh sock puppet and the question as to whether Lott fabricated research before dismissing Lott’s argument that carry laws caused crime to fall, citing Ayres and Donohue’s refutation of Lott’s studies.

So I have a question. Why do sellers agree to use auctions to sell their houses? Auctions are good deal for the agents, because they sell the house quickly, but they won’t give the sellers the best price. While most houses in this part of Sydney are sold by auction, it’s easy to find an agent who will sell it the other way. So why use a method that won’t give you the best price? Give me your answers in comments.

Comments

#1 Verbal
April 12, 2005

Well, in many cases the seller has to sell in a certain amount of time, because they have to have the proceeds from the sold house to put money down on the next one. That transition can be a dangerous one– if you’re moving out of town, you may end up with money down on a new home you can’t occupy ’til closing, owning an empty home you can’t sell back in the old town, and paying rent on a temporary home to actually live in. Having a home on the market for a long time is a terrifying experience, and a quick sale, while not always in the economic interest of the seller, is psychologically satisfying.

Buyers, too, tend to be suspicious of anything that’s been on the market for a long time: looks like it’s overpriced. So my guess is that while an extra 10 days might help find the right price, an extra month would start to look like you were overpricing…
#2 Alastair
April 12, 2005

If it was in the agent’s interest to sell the house quickly, surely they would have pressed you to make an offer before the auction? From what you have said here, the fact that the house even went to auction implies that the agent was acting in the best interest of the vendor, even though that was based on the mistaken belief that the vendor would get more than your offer. I can’t believe I’m defending real estate agents in public, but there it is…
#3 Simon
April 12, 2005

Alastair,
Real Estate agents charge the vendor for the auction – the agent makes more money by allowing the auction to proceed, pocketing the commission on the sale of the house and the auction fees.
#4 Tim Lambert
April 12, 2005

Actually, the real estate agent did press us to make an offer before the auction. Since he had more information than us about how much interest there had been in the house, we decided that it was in our interest to see how the auction went.
#5 Meyrick
April 12, 2005

It’s all relative! Just because the auction fails to get the “best” price, what’s to say the other methods will get the “best” price? Each method of selling a house must be compared to each other rather than some theoretical ideal.
#6 David Tiley
April 12, 2005

But I bought a house in the bush, making an offer immediately. The next person on the block offered more, but I was already in. So it had been underpriced. However, in a rising market with not a lot of sales around the neighbourhood, setting that price was a guess.

I’ve also sold a house by auction for the same reason. I figured I set the local price by the auction and the next few could be sold privately. Auctions are good when the market might be undervaluing houses.
#7 Harald Korneliussen
April 12, 2005

The book is now placed on my amazon wishlist, for lack of a better place

Apropos auctions, I came to think of auctions the other day when I read about two german board games which use auctions as a game element – one uses a form of blind bidding, the other uses so-called dutch auction. I’d love to read a game-theoretic explanation of the virtues of different auction types, do anyone know about one?
#8 Rob
April 13, 2005

Tim —auction design is a huge section of economics. Why would they use an open auction? Because it will still extract more than a normal listing. Say there are 5 bidders on a house. Now if each bidder knew what the other valued the house at, the clearing price would be the second highest bidder’s value + epsilon with the person placing the highest value on the house paying that price. With an open auction in general otehrs values are unknown, so you’ll end up with an amount greater than second highest vlaue + epsilon.

Compare that with an open listing where the seller has to gauge what the highest person’s value is. If they go to high, no sale. Too low and they might end up with the second or third highest valuation.

To actually get the most out of a buyer, a sellar should move to a close bid auction which tends to force people to committ to what their valuation is.
#9 emmaco
April 13, 2005

I’m a bit puzzled by what you’re calling an open auction, Rob. In an asecending price auction where people call out their bids, other bidder’s values are revealed. Watching other people’s bids might encourage people to bid their true value as they aren’t scared they are overpaying for an item. A closed bid auction may have bidders shading their bids downwards because they are worried about overspending.

So an auction may lead to you getting a higher price for your house because the person who wins (paying the second higherst bidder’s value plus epsilon like Rob said) may not have submitted this price in a closed offer.

The economic theory is pretty complex as there are lots of different factors involved, such as risk averseness of bidders. I find Paul Klemperer’s work on auctions quite accessible – he has some downloadable papers at http://www.paulklemperer.org/ or a collection in his book “Auctions: theory and practice”.
#10 Rob
April 13, 2005

Bids are only revealed to a point. The top valuer never actually knows when exactly the second highest bidder will drop out. Since bids don’t come in infentesinally small amounts, you tend to get overpayment. If there are enough bidders is a closed bid auction, you are willing to pay up to your true value. If you think someone might have a vlue fairly close to yours, you are willing to outbid them up to your true value.

Of course as you add more bidders, the winner’s curse becomes more of an issue.
#11 dsquared
April 14, 2005

Ten days really isn’t all that long and 3% really isn’t all that much in the context of a house sale. If the average punter gets within 3% as good a job as the estate agent does on his own house, then it doesn’t strike me as obvious that he’s getting a raw deal. I’d love to eat at a restaurant and get a meal 97% as good as they served the guy who owns the place.
A fair couple of Levitt’s most famous pieces seem to me to gain quite a bit of their oomph from failure to observe the distinction between statistical and practical significance; I think I need to buy the book to see if this assessment is in any way fair.
#12 Tim Lambert
April 15, 2005

Actually, 3% isn’t much on a loaf of bread, but it is $10,000 or more on a house sale. If I’m selling my house $10,000 is most definately of practical significance to me.

I’ve thought of a reason why sellers might choose auctions — they don’t trust real estate agents to accurately tell them the market value, so they go for an auction, even though that sets the price to that of the second highest bidder.
#13 dsquared
April 15, 2005

I’m not so sure about this; if you saw a house on the market for $300k and you offered $290k, would you think you were making a ludicrous lowball offer that was bound to be turned down? Or would you think that you were making an offer pretty near the seller’s price and that the extra $10k was really neither here nor there? I suppose the lesson here is that people talk about statistical rather than practical significance for a reason; practical significance is very subjective and varies from person to person.
#14 Rob
April 16, 2005

Lets say you owe 200K on that 300K house. Suddenly your talking about a 10% reduction in value.
#15 Mark U
April 16, 2005

My experience in Brisbane is that even in the strong market over the last three or four years, houses are most of the time passed in at auction. I think this is because the contract conditions for buyers are less favourable in an auction sale.

Personally, I think a closed tender process has the advantage that if someone really wants your house they are more likely to reveal their true valuation. At an open auction they will only pay a small amount above the second bidder’s true valuation. If houses were a uniform good where individual valuations did not diverge much there would not be much difference in outcomes, but people can make widely different assessments about houses. I happen to hate imitation Tuscan style houses but other people out there love them.
#16 James B. Shearer
April 19, 2005

Tim Lambert, do you have an opinion on the legalized abortion leading to a later drop in crime theory? Steve Sailer claims that looking at age-specific crime rates refutes it.
#17 ChrisPer
April 19, 2005

There are a couple of points worth noting here. THere is plenty of argument around about auctions or not. It is clear that the auction in your case did not pull your top price but the underbidders top price plus ‘epsilon’. But auctions create an artificial scarcity for the competing bidders, creating a major emotional push to take a step beyond their rationally determined top. Happens all the time, thats why auctions are good for sellers IF you can bring two or more determined buyers to bid. If not, that is a serious failure.

Tim is right about the value of that 3%. It isn’t money you own now but money at the far end of a mortgage. 3% of gross at a 25-year distance is a hell of a lot of money.
#18 dsquared
April 19, 2005

3% of gross at a 25-year distance is a hell of a lot of money.
But “a hell of a lot of money in 25 years time” trades at a substantial discount to “a hell of a lot of money right now”. Mere compounding over time can’t change whether something’s important or not; the rate of exchange between “jam today” and “jam tomorrow” is measured by the interest rate. Like I say, if you put your house on the market for “300,000 and got an offer of “290,000, would you call that an offer near the asking price which was worth considering, or not?
#19 Tim Lambert
April 20, 2005

James, in the page on his blog on the issue, Sailer does not link or mention Donohue and Levitt’s response to the age-cohort argument. Any age-cohort comparison needs to control for the effects of the crack wars and Sailer’s graphs don’t do that. I don’t find Sailer’s argument persuasive and I don’t think he had fairly presented Levitt’s response to it.
#20 Steve Sailer
April 27, 2005

I introduced Levitt to the fact that the crack wars had happened when I arranged for him to debate me in Slate.com way back in 1999. I provided him with the answer he’s used ever since.

But, the question I asked then is why the crack wars tended to start about 17 years after the legal abortion rate went up in a location. He’s never wanted to investigate that question, just why the crack wars wound down about 22 years after abortion was legalized. Apparently the effect of legalizing abortion grows stronger the more years intervene!

His publicist asked him to debate me again this year to promote his book, but he refused.

You can read all about the controversy at http://www.iSteve.com/abortion.htm
#21 Tim Lambert
April 27, 2005

Sorry, Steve, but your question makes no sense. I don’t think anyone is asserting that abortion started or ended the crack wars. If you want to work out the effects (if any) of abortion you have to subtract out the effects of crack. You don’t do this while Levitt does, which is why I don’t find your argumants persuasive.

I also note that you don’t link or mention their response.
#22 dsquared
April 28, 2005

I don’t think anyone is asserting that abortion started or ended the crack wars

As I read him, I think that Steve is; he thinks that abortion “thinned out the respectable black working class” while not thinning out the black underclass. He doesn’t have any data to support this hypothesis, but then I don’t find Levitt’s use of the crime data particularly convincing either so I would say that both sides are on an even footing.

I also don’t really agree that Levitt adjusts for crack in any way that instills any confidence at all; the size of the event study is not big enough to do so, and I think Steve’s response to Donohue’s point 3 (that the generation who were teenagers during the crack wars would be likely to have lower crime rates for the rest of their lives because so many of their criminal element was in jail or disabled) is actually quite telling. In particular, I find Donohue’s assertion at the top of page 44 that “one would expect similar crime rates pre-crack, crime rates that were especially elevated in the late 1980s and presumably similar or still elevated crime rates in the 1990s as crack weakens but does not disappear” to be unconvincing; one of the things we do know about crackheads is that they tend to either go straight or die rather than continuing in the crackhead lifestyle until a ripe old age.

As far as I can tell, Freakonomics isn’t out in the UK yet but I’m becoming a bit of a sceptic. I think that the attempt to link abortion with crime rates at a gap of 18 years was a silly idea in the first place; whatever happened, the data were never going to be able to prove the effect one way or t’other.