Getting Smacked Down When Trying to Propose a More Efficient Contract
posted by Scott Moss
You might think a real estate brokerage would being offered a more generous commission, but you’d be wrong. I’m working on selling my house, and I met with Very Big Brokerage, whose standard form explains their commission: 6%. I made a counteroffer, which I knew was unorthodox but thought they’d like. They thought my house was worth $320K, so I proposed that they get 9% of the amount of the sale price above $90K. So if they sell it for $320K they envision, they get not the $19.2K they proposed (6%), but $20.7K (9% of price-$90K). { Note: 320 and 90 aren’t the actual numbers, but I kept the proportions the same from the actual numbers. }
I wanted a higher marginal rate (9%, not 6%) so they’d have more incentive to maximize sale price: each additional $10K would net them $900, not $600. I made the starting point low, $90K rather than $106.6K (1/3 of anticipated sale price, the “revenue neutral” threshold for increasing the commission percent by half), just as a kicker to them, to make them more likely to agree to my plan.
I thought this would be Don Corleone’s proverbial “offer they can’t refuse,” but apparently the appropriate cultural reference wasn’t Marlon Brando’s Godfather, but Mike Myers’s Lothar of the Hill People: “It is a good idea, but it is a new idea. So we fear it and we must reject it.” (Incidentally, does anyone have a link to this quote? I can’t find anything, which shows the obscurity of this early 90s second-rate Mike Myers character I like.) My broker said she liked it but her boss didn’t; the two specific problems she mentioned are (1) payroll would have a hard time processing this, and (2) they often have to split commissions with other brokers, which would be hard with an unusual rate. (I won’t waste blog ink rebutting these rationales.) The mischief-maker in me wanted to say, “it’s my deal or no deal,” and I bet they’d've budged. But I liked my broker, and she would’ve hated me starting a pissing contest, which might’ve jeopardized the whole point of my plan — to optimize her incentive to work on my behalf.
But there’s a serious point here: a win-win deal was rejected on inane bureaucratic grounds by a major, successful capitalist enterprise that should understand commissions and valuations far better than I. Two of my fields are economics and employment discrimination; a lurking question at the intersection of both fields is: why would a business discriminate, an inefficient decision to turn away good talent? There are several answers (unless you’re Richard Epstein, in which case the simple answer is, “firms don’t discriminate, or they do and it’s efficient, and in either case we don’t need discrimination laws”), but the one illustrated by my broker story is: just as good people do bad things, good companies do dumb things due to a combination of managerial laziness, risk-aversion, status quo bias, etc. Some of the most successful employers subvert themselves by rejecting talented workers, and some of the most successful realtors subvert themselves by rejecting a great deal that almost certainly would net them more money and maximize their brokers’ incentives to maximize sale price.
March 27, 2007 at 9:11 pm
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Responses (22)
Edward Still - March 27, 2007 at 9:53 pm
Once upon a time I had a case against my former Civil Procedure professor. During the usual fat-chewing that goes on between lawyers, he mentioned that the bond lawyers in his firm had two answers for every “why” question about the wording of bond issues: “We have always done it that way” or “We have never done it that way before.” Sounds like the same thing as with your real estate broker.
Never underestimate the power of inertia on humans.
Jeff Lipshaw - March 27, 2007 at 10:40 pm
Scott, you are the economist, not I, but my understanding of the structure of the market is as follows. If you were to have listed the house that way, your listing broker would be obliged under its agreement with the multi-list service to advertise its commission arrangement with you, because the selling broker who might split the commission is entitled to understand the basis for the compensation. And because the driving economics of the business are churn, not size, there might be transaction costs in having to explain the fee structure to selling brokers that offset the potential gain. Or is the term network externalities? It is a more efficient system when it is kept simple.
Jeff Lipshaw - March 27, 2007 at 10:42 pm
I should add that I have had my most success with brokers and their commissions when we set the commission at the local going rate, we find a buyer, the buyer and I are still some distance apart, and I suggest to the broker that the deal will only be made if the broker now takes a haircut on his or her commission.
Scott Moss - March 27, 2007 at 10:55 pm
Jeff: Yes, there are economies of scale from using standard (rather than customized) contract terms; I think Robert Scott or somebody wrote a L.Rev. article on that. And while I know zip about the logistics of the industry, I have trouble believing that a probable extra $1K-2K commission wouldn’t be worth the hassle of some disclosure.
Of course, you certainly may be right that industry standard practices make it costly to deviate — but that’s just to say that the gravitational pull of standard practices deters inefficient innovation. It’s still a story of inefficiency, just one of rational inefficiency (not the lame/dumb inefficiency I suggested).
Dan Filler - March 27, 2007 at 11:37 pm
I suspect part of the problem is that the upside to the deviation was insufficient to break inertia and/or compensate for transaction costs. That $1-2K will be split by at least four parties: the seller and buyer broker, and the owners of their respective agencies. At $500 each, this is far less attractive than it might seem. (And remember that brokers, who want to close deals, make it their business to nudge clients not to haggle over a thousand or two here and there. Perhaps they just take their own advice.)
Eric Goldman - March 27, 2007 at 11:45 pm
Scott, I don’t think you can discount the intra-firm transaction costs. I can assure you from first-hand in-house experience that we could barely manage standard deals, let alone anything custom. Eric.
anon - March 27, 2007 at 11:49 pm
I would bet that the brokers also feared that you were trying to pull a fast one on them — you’re a law professor, for God’s sake: this is a country that doesn’t trust lawyers, and hates intellectuals. The brokers didn’t want to take the time to go through the proposed contract and then out of an abundance of caution (distrust) run it by their lawyers (whom they are probably loathe to call (pay)) just to make sure you weren’t pulling a fast one. So, yes, the brokers would rather use their time closing deals. Time spent deviating from their field/expertise is time they’re not making money.
Jeff Lipshaw - March 28, 2007 at 7:50 am
To Dan’s correct point about the four way split, if you can buy from the listing broker so that the commission is only split between the agent and broker in one shop, you have a better chance of getting the haircut.
Matt Bodie - March 28, 2007 at 8:52 am
One other (pessimistic) thought: your commission was designed to reward the upside and punish the downside. Maybe they are worried about their ability to sell it for $320K in a slow market.
Fred Tung - March 28, 2007 at 10:11 am
On the “pulling a fast one” problem, Omri Ben-Shahar and John Pottow have written a paper discussing this phenomenon: On the Stickiness of Default Rules, 33 Fla. St. L. Rev.651 (2006). Basically, people are suspicious of deviations from the norm, such that they may reject deviations that a “rational” actor would understand as beneficial.
On the inanity of bureaucracy, it wouldn’t be surprising to me if the Very Big Brokerage simply didn’t give much discretion to individual brokers to deviate from the standard deal. The costs and risks of analyzing individual commission proposals may simply not be worth it. Organizations always need marching orders for the troops. Junior associates don’t get discretion to negotiate billing rates, for example. In individual cases, the marching orders may not make sense, but for the organization as a whole, it may be optimal.
mmmbeer - March 28, 2007 at 11:10 am
I will second the intra-firm costs rationale. In actuality, even discussing the change probably cost them more than they might have earned: the time for consideration by several people is probably less than the added value of the deal.
Moreover, whatever extra money made is certainly shared among a number of people/entities. There would be additional transaction costs for them as well making it considerably less likely that they would accept your offer.
David S. Cohen - March 28, 2007 at 11:44 am
I suspect Matt’s correct. They’re just not confident they can get the $320k. So, they’d rather have the standard 6% on everything than the riskier, but possibly more rewarding, 9% on the balance over $90k. It seems like a pretty classic case of taking the conservative, less risky route over a more aggressive, but higher risk, route. I’m not an economist, but isn’t that rational economic behavior? Especially if the housing market in Milwaukee is in line with the declining housing market nationally?
Scott Moss - March 28, 2007 at 12:40 pm
All good points; two responses:
(1) True, they may not be confident they’d get $320 — but that’s why I made the threshold only $90K, b/c with that low a threshold, my formula works better for them as long as they sell for $270.
(2) True, it may be rational for the organization to reject any modifications of their standard contract — but that’s to say that they still are rejecting possiblly more efficient contracts because transaction/agency/other costs prevent them from trusting their employees to exercise judgment in accepting a good deal.
Matt Bodie - March 28, 2007 at 12:43 pm
One more (optimistic) thought: it looks like the point at which your commission becomes lower than the standard 6% is at $270,000. (I know these aren’t your actual numbers, but they’re a reference.) So that’s a pretty big drop. They probably wouldn’t be listing the house for $320,000 if they thought it would go for less than $270,000. That’s more than 15% less. So perhaps it is inefficient “stickiness” on their part. But the difference between your commission and the standard commission does narrow as the price drops.
Matt Bodie - March 28, 2007 at 12:48 pm
Looks like we crossed comments — I agree that there’s some stickiness involved here (unless they’re really aggressive in their pricing).
David S. Cohen - March 28, 2007 at 1:09 pm
Looks like we crossed comments — I agree that there’s some stickiness involved here (unless they’re really aggressive in their pricing).
Or if they’ve got non-trivial concerns about the market tanking and the negative result if that happens is much worse to them than the positive possibility of them selling the house for more.
Robert Rhee - March 28, 2007 at 3:55 pm
We’re also assumimg that the initial representation of $320K was accurate, and not a part of the initial negotiation to get the contract by the agent. These days, housing prices are repriced quite often (“Reduced Priced” signs on lawns). There may be information asymmetry considerations here. Perhaps the anticipated distribution of sales price is not evenly distributed, but is in fact skewed and the agent knows this.
Robert Rhee - March 28, 2007 at 5:17 pm
Further thought on my last point is that the anticipated surplus profit of $1500 diminishes by about $1000 for every 10% decrease in the sales price of $320K (assuming that the buyer agent insists on the standard 3% of the sales price). In this case, which is plausible in the national market (though I have no clue about the Milwaukee housing market), the surplus profit to the seller agent is $500. Given all the other considerations suggested by the other bloggers (transaction costs, resistence to buck industry pricing, etc.), it just may not be worth the extra few bucks. This also assumes that the housing market is not heated and that we would not expect a bidding contest in excess of the list price. I suspect, however, that as the home price increases, the incentives start to amplify, and thus we would expect deviations from the industry norm in high end homes.
geoff - March 28, 2007 at 5:54 pm
Scott–You wrote this:
But this reflects one of the great, enduring and frustrating fallacies of much “economic” analysis. What is efficient cannot be defined in a vacuum. In fact, efficiency must account for the costs of getting from here to there. It may not be at all inefficient for the brokerage not to trust their employees, if marginally more trust would be costly to the firm, even if in this instance it would pay off.
And it is not appropriate to use this fact to argue that the firm is behaving inefficiently. The firm is not necessarily “subverting” itself. The reality is that information is limited and costly and agency costs are very real costs, so some decisions must be made “imperfectly” when judged against a non-existent optimum. But that doesn’t mean they are sub-optimal; it only means Utopia is not the appropriate standard against which to judge (This is what Harold Demsetz brilliantly dubbed the “Nirvana Fallacy.”).
Don’t get me wrong–firms make mistakes all the time, of course, and this may be one of those times. But neither you nor I has anywhere near enough information to make that determination.
anon - March 28, 2007 at 6:02 pm
Does Economic Man really exist?
originalbob - March 28, 2007 at 7:11 pm
I am the selling agent, with a hot prospect in the passenger seat, heading for SM’s neighborhood. House #1 earns me 3%; house #2 earns me, what? 4 1/2% of $90k, no that’s not right… Do I bother to do the math? Do I even show house #2 to my prospect?
I am heading for house #1 for my 3%. The seller’s agent makes the sale.
Better: 2% to listing agent; 3% to seller’s agent.
Mark Seecof - March 30, 2007 at 1:54 pm
And don’t forget the broker’s other goal: to holding the line on commissions. Even if your deal were more lucrative for the broker it would still be non-standard, informing other prospective customers that the commission rate is negotiable. Brokers don’t want to negotiate rates because they fear they will go down more often than up. (Real estate brokers aren’t (so) stupid, they see how negotiable commissions played out in, say, stockbroking.) Indeed, other agents and brokers will ostracize brokers and agents who negotiate on commission. The “Realtors” cartel goes to great, even obviously unlawful, lengths to enforce the fixed commission.
So even if you were willing to offer enough to overcome inertia, transaction costs of processing a non-standard deal (including perhaps getting it reviewed by lawyers, etc.), you might still be stymied by brokers’ long-run interest in maintaining the fixed commission.
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