Homo Economicus and Home Buying Economics

Economists often find themselves the target of criticism for their tendency to portray individuals as homo economicus, a notion of people as perfectly rational beings engaged in emotionless financial decision-making. However, it’s essential to clarify that no competent economist genuinely subscribes to this view any more than a physicist believes that billiard balls are flawlessly spherical, gliding across a frictionless surface. Just as a physicist might simplify the complexities of a game of pool for practical purposes, economists sometimes rely on simplified models of human behavior. Yet, it’s crucial to recognize that these assumptions are not universally valid or applicable to every scenario.

One particular area where the homo economicus model can lead to misguided strategies is in the realm of homebuying. Recently, I came across a mechanism known as an escalation clause that buyers can include when submitting an offer to purchase a home. This concept bears resemblance to a feature on eBay: when bidding on an item, you might set an initial bid of $50 but also configure it to automatically increase up to a specified limit, say $100, whenever competing bids appear. This approach allows bidders to avoid the hassle of constant monitoring throughout the bidding process.

An escalation clause operates in a similar fashion. For instance, consider a house listed for $500,000 (or, in the quirky real estate market of San Francisco, perhaps a hammock nestled in a garden shed). An offer using an escalation clause might state, “I’m offering $500,000, but I will raise my offer in increments of $5,000 above any competing bids, up to a maximum of $560,000.” In a recent conversation with a real estate agent, I inquired about the prevalence of such clauses in offers.

To my surprise, she strongly advised against including an escalation clause. According to her, offers with these clauses are often overlooked in favor of other offers that might initially seem lower but lack the complexity of an escalation clause.

Why does this eBay-style strategy falter in the housing market? The key lies in the asymmetric knowledge inherent in eBay bidding. As a bidder, you are aware of your maximum willingness to pay, say $100, while the seller is in the dark about your true limits. If the bidding escalates to $75, the seller might reasonably believe that was your best offer. They understand buyers typically wish to minimize spending, while sellers aim to maximize return, creating a plausible scenario where the seller feels they have received a competitive offer.

However, the introduction of an escalation clause fundamentally alters this dynamic. By stating your willingness to pay up to $560,000, you explicitly inform the seller of your financial capacity. You’re essentially saying, “I’m only offering you $500,000 right now, but I can go higher if someone else does.” If a competing offer comes in at $530,000, the rational homo economicus would suggest that the seller should accept your escalated bid of $535,000. Yet, in reality, many sellers would likely opt for the straightforward $530,000 offer, even if it’s not the highest bid they could have received.

This tendency arises from the inherent desire for sellers to feel they are receiving the best possible offer. Even if the $530,000 bidder could have stretched their budget, the absence of an escalation clause allows the seller to believe that this was indeed their best offer—much like an eBay seller might assume. It turns out that a significant number of sellers would rather forgo an additional $5,000 than engage with a buyer they perceive as attempting to lowball them. While this decision may cost them, it fulfills a psychological need for respect and fairness in the negotiation process.

It’s essential to clarify that these observations do not indicate a flaw in economic theory. Any reasonable economist recognizes that non-monetary factors significantly influence decision-making. For instance, the relatively modest wages earned by astronauts, despite the demanding and perilous nature of their work, can be attributed to the considerable non-monetary benefits associated with the profession—namely, the immense prestige and fulfillment that come with being an astronaut.

To wrap up, I pose a question to readers: what non-monetary benefits or costs have shaped your decisions regarding jobs, transactions, or similar choices?