When you are looking for a house, one of the first questions the real estate agent is likely to ask is how much you can afford to spend. The prudent customer will think twice before giving an honest answer. Realtors, after all, are paid a commission based on the price of the house. If you tell her you can afford a four hundred thousand dollar house she may, if she is competent, find you the best four hundred thousand dollar house in the city. But she has little reason to look for a three hundred thousand dollar house that is almost as good.
I have a solution to this problem, although an imperfect one. What you want is not the best house you can afford but the house that gives you the maximum surplus, the largest possible difference between what it is worth and what it costs. If that is the house you want, perhaps you ought to reward the realtor on the basis of how good a job she does of finding it.
Under my system, each time the customer looks at a house he tells the realtor what is the highest price he would pay for the house. In order to keep the benchmark from changing during the process, that price should be defined on the assumption that the alternative is renting, since otherwise it will in part depend on the other houses he has so far seen. When the customer finally buys, the realtor's commission is a percentage of the difference between the highest price the customer said he would pay and the actual price paid.
This system has two advantages. First, it gives the realtor acting for the buyer a direct financial incentive to do as good a job as possible of helping the buyer bargain the seller down. Second, it gives the realtor an incentive to find the right house, the house that maximizes the net benefit from buying it.
It is an imperfect solution for at least two reasons—putting aside the difficulty of getting the profession to adopt it. The first is that the customer has some incentive to lie, to understate the value of each house to himself in order to reduce the commission he will have to pay if he buys that house. The second is that it ignores the cost of search to the realtor. As long as a dollar's worth of extra search produces more than a dollar's increase in net benefit, it is in the joint interest of realtor and customer to continue searching. But the realtor gets only a fraction of the net benefit as commission, so it is in her interest to stop searching well before that point.
One possible explanation for the present system is that people regard a house as a good investment—the interest is tax deductible, and everyone knows, or used to, that house prices always go up. If it is a good investment, it makes some sense to buy the most expensive house you can finance, even if the actual benefits of living in the house don't justify doing so.
That argument looks less convincing now than it did a year or two back.
I have a solution to this problem, although an imperfect one. What you want is not the best house you can afford but the house that gives you the maximum surplus, the largest possible difference between what it is worth and what it costs. If that is the house you want, perhaps you ought to reward the realtor on the basis of how good a job she does of finding it.
Under my system, each time the customer looks at a house he tells the realtor what is the highest price he would pay for the house. In order to keep the benchmark from changing during the process, that price should be defined on the assumption that the alternative is renting, since otherwise it will in part depend on the other houses he has so far seen. When the customer finally buys, the realtor's commission is a percentage of the difference between the highest price the customer said he would pay and the actual price paid.
This system has two advantages. First, it gives the realtor acting for the buyer a direct financial incentive to do as good a job as possible of helping the buyer bargain the seller down. Second, it gives the realtor an incentive to find the right house, the house that maximizes the net benefit from buying it.
It is an imperfect solution for at least two reasons—putting aside the difficulty of getting the profession to adopt it. The first is that the customer has some incentive to lie, to understate the value of each house to himself in order to reduce the commission he will have to pay if he buys that house. The second is that it ignores the cost of search to the realtor. As long as a dollar's worth of extra search produces more than a dollar's increase in net benefit, it is in the joint interest of realtor and customer to continue searching. But the realtor gets only a fraction of the net benefit as commission, so it is in her interest to stop searching well before that point.
One possible explanation for the present system is that people regard a house as a good investment—the interest is tax deductible, and everyone knows, or used to, that house prices always go up. If it is a good investment, it makes some sense to buy the most expensive house you can finance, even if the actual benefits of living in the house don't justify doing so.
That argument looks less convincing now than it did a year or two back.
