As a student of economics, I have long marveled at the intricacy and mathematical beauty of microeconomic models. They seem to explain so much about the world in which we live and why we do what we do - except when they don't.
And a stark reminder of these limitations was on stage in an article titled "A Reality Check for Home Sellers" in yesterday's New York Times.
The story offered a prescriptive for seller behavior grounded in economic rationality without consideration of an even more powerful forces - psychology and utility.
While discussions of utility in neoclassical economics are generally absent of behavioral impacts, and merely seek to quantify rational trade-offs among economic goods, utilitarian explanations take into account consumer psychology and offer a more robust framework for understanding motivations and their implications for policy-making.
Preference utilitarianism, as put forth by Peter Singer, seems to be the most useful model for understanding the behavior described in today's article than more classical economic frameworks. It takes into account the uniqueness of each individual's perspective and validates their actions as being rational - for them. And this happens to describe the world in which we live, a world that is perceived differently by each economic actor.
Their study, “Loss Aversion and Seller Behavior: Evidence From the Housing Market,” appeared in The Quarterly Journal of Economics in November 2001. The professors gathered data on almost 6,000 Boston condominium listings from 1991 to 1997 and showed that for essentially identical condominiums, people who had bought at the peak and were facing a loss generally listed their properties for significantly more than those who had bought at a time when prices were lower.
Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.
In classical economics, that’s not supposed to happen, but the episode did comport with the behavioral economics theory of loss aversion: people have a visceral — some might say “irrational” — hatred of losing money. They try to avoid doing so, even when it goes against their own best interests.
So by being hung up about whether your condominium will sell for what you paid for it, you aren’t just driving yourself crazy trying to get a buyer. You may be threatening the very performance of the economy and driving up the unemployment rate — provided that many others behave in a similar way.
What is to be done? Well, if you are holding out for an above-market price to recoup your losses, perhaps you would do well to hear the advice that Professor Mayer gives his own family members.
“If you want to sell your house then you list it at the market price and you sell it,” he said. “If you don’t really want to sell then don’t put it on the market. But don’t say you want to sell and then set the price so high that you spend the year cleaning up every morning, having people walk through your living room and look in your medicine cabinets and reject you. That’s just painful — and expensive.”
His research offers a simple lesson for everyone out there waiting for a high price to push them back into the black: Get real.
You know what struck me when reading this article - one could replace the word "condominium" with "stocks" and you'd have the exact same effect. In general, retail investors hate selling losers. There is a psychological barrier to taking a loss, admitting a mistake, even if it is economically prudent to do so.
How many people do you know that held on to stocks from $60 down to $1, even when they really thought they should get out at $30? I personally know dozens. The concept of sunk costs gets thrown out the window when emotions get involved. As I've written previously, humans are not wired to always make rational economic decisions, though they are wired to always seek to maximize their utility. A discussion of consumer behavior in the absence of psychology and utility is almost valueless.
In the case of the Boston condo market, while it might not be economically rational to hold on in a depressed market, it would clearly cause greater emotional costs to sell than the economic benefits it would generate. And economists themselves just need to "get real" - people don't want rational economic explanations as a prescriptive for their behavior. They want to feel good. And if feeling good means holding on to losers, then this is what they'll do, regardless of what big-brained economists may say.
Therefore, policy-making needs to take into account consumers' inevitable "irrational" behavior, as this is a constraint that is very real, time-tested and one of the few immutable certainties of life.