Homo Economicus And Home Buying Economics

Economists are often criticized for assuming people behave like homo economicus – some kind of perfectly rational machine making emotionless decisions based entirely on money. Of course, no competent economist actually thinks this way, just as no competent physicist believes that billiard balls are perfectly round spheres operating in a vacuum on a perfectly flat, frictionless surface. But just as a physicist, while playing a game of pool, might find it useful to model the pool balls and table as if that was the case, there are also cases where economic models might usefully employ simplified understandings of human behavior. But nobody actually thinks these simplifying assumptions are literally true, or even useful in every analysis.

One area where the homo economicus model assumption can be counterproductive is in homebuying. I recently learned about a clause that’s sometimes used when people submit an offer to buy a house, called an escalation clause. It works in a way that’s similar to a feature you can use on eBay. When bidding for an item on eBay, you can set your bid to, say, $50, but also program it to nudge your bid all the way up to a set amount, say $100, whenever anyone else makes a bid between your starting point and your upper bound. This saves you the time and effort of having to continually monitor an item during the bidding period.

An escalation clause works something like that. Suppose there’s a house for sale for $500k. (If the bidding is taking place in San Francisco, assume it’s a listing for a hammock set up inside a garden shed.) An escalation clause in an offer might say “I’ll offer you $500k, but I’ll increase my offer in $5k increments above any other offers you receive, up to $560k.” I recently had a discussion with a real estate agent and asked about these clauses, and how often they come up.

She told me that she and other realtors strongly advise against including an escalation clause. Offers containing these clauses, she explained, are actually more likely to be passed over in favor of offers that still fall below the set upper bound.

So why does this eBay style approach backfire when bidding for a house? Well, in eBay, the knowledge about the difference between your current bid and your maximum willingness to pay is asymmetric. You know that you’ll bid as much as $100 for the item. But the seller of the item doesn’t know that. If the eBay system sends your bid up to $75, for all the seller knows, that number was also the best you were willing to offer. Obviously they know that buyers prefer to spend less and sellers prefer to sell for more, but it’s at least plausible for them to feel like they got the best offer they could have gotten.

But an escalation clause takes that away. In putting down an escalation clause, you are explicitly telling the homeowner “I like your house enough to be willing to pay $560k, and I can in fact afford to pay $560k for it. However, I’m only going to offer you $500k right now, unless someone else gives me a reason to offer you something better.” Suppose in that case, a second offer comes in that’s just a straight offer of $530k. Homo economicus would then accept the bid from the offer with the escalation clause for $535k. But most people will choose the $530 bid, even though it wasn’t actually the highest bid they could have gotten.

This is because people want to feel like they’re getting your best offer when you make a bid on their home. And even if the person making the $530k bid might have been willing and able to pay more than that, the seller doesn’t actually know that. Because the offer didn’t make it explicit through an escalation clause, the seller can still plausibly retain the feeling that this buyer was making their best offer, just as an eBay seller can think. And it turns out that the majority of people will pass up on an extra $5k to avoid doing business with someone they feel was trying to lowball them. It may cost them an extra $5k, but it makes them feel more respected.

To be clear, none of what I’m writing about right now is showing some flaw in how economists understand the world. Any halfway competent economist understands that nonmonetary factors matter in decision making. Nonmonetary factors help explain why astronauts, despite doing some of the most physically and mentally challenging and dangerous work on the planet make a much lower wage than one might think – because being an astronaut is itself a huge nonmonetary benefit!

A question for the readers – what are some nonmonetary benefits (or costs) that have influenced your choices regarding jobs, transactions, or other similar decisions?