Real Estate Commissions

There is an interesting post on Marginal Revolution about the commissions that real estate brokers charge. Alex Tabarrok wonders why these commissions (combined buyer and seller agent) are steady at 6%. In Washington D.C., where prices having going up, we would expect to see that competition amongst the real estate agencies would drive down these fees. Instead, we see more agents entering the field and competing for the same client pool, but no reduction in the fees. This would be inefficient rent seeking because a smaller number of agents could do the same work for a lower overall price.

I argued in the comment section that the most likely reason that these agencies don’t reduce these fees is that they recognize that they are playing a classic Bertrand price competition game. In such a game, if any player lowers the price, all players will have to match it, and all players will lose profits. So players realize that they are better off just doing what everybody else is doing. This is especially true in a profession like real estate where potential competitors often have to cooperate. Keep in mind that the buyer’s agent has to negotiate with the seller’s agent, so yesterday’s competitor might be someone he or she needs to work with tomorrow. They don’t want to slit each other’s throats.

But there is another mystery about real estate commissions: who decided that a fixed percentage of the home sale price was a good basis for determining the commission? Consider this example: you have a house that your agent knows should sell for about $400,000 but it might sell for $390,000 or for $410,000. So if he works really hard, he will get a commission of 3% of $410,000, which is $12,300, but if he slacks off he will get only $11,700. He would rather get 12 commissions of $11,700 than 11 commissions of $12,300. With this kind of incentive, it is obvious that the agent only wants to sell your house as quickly as possible for the lowest price he can persuade you to accept. He is motivated in exactly the wrong way.

A more sensible way to motivate real estate agents is to base the commission closer to the value added of his services. He knows he can sell your home for 95% of $400,000, so he says: “I will guarantee that your house will sell for more than $380,000 and I will keep 60% of anything above $380,000.” If the house sells for $400,000 like he expects, he will get $12,000, which is 3% of the house value. But now he is much more motivated to push the price well above $400,000. Anything over $400,000, both the agent and the homeowner win.