Impossibility of Competitive Equilibrium in the Real Estate Brokerage Industry

By Yavas, Abdullah | The Journal of Real Estate Research, May/June 2001 | Go to article overview
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Impossibility of Competitive Equilibrium in the Real Estate Brokerage Industry


Yavas, Abdullah, The Journal of Real Estate Research


Abstract

This note shows that the presence of fixed costs (eg., licence fees, fees for local, state and national realtor associations, continuing education expenses, some of the office expenses, etc.) in the real estate brokerage industry makes it impossible to have competitive commission rates as the equilibrium outcome. In fact, the only pure strategy Nash equilibrium involves monopoly commission rates. This outcome compels alternative equilibrium explanations for the industry and for the future research on brokerage.

Introduction

Fixed costs in the brokerage industry are prevalent. Agents and brokers have to pay license and license renewal fees, fees for local, state and national realtor associations, fees to the local Multiple Listing Service and continuing education expenses. In addition, a major part of the expense related to the operations of the brokerage office is also fixed costs (rents due to annual or longer term lease contracts, office equipment purchases, certain maintenance expenses, etc.).' Most of these fixed costs are incurred on a periodic basis, some monthly and some annually. The purpose of this note is to show that the presence of fixed costs has a critical implication for the competition in the brokerage industry: it makes it impossible to obtain the perfectly competitive outcome as a pure strategy equilibrium where agents/brokers compete with each other on the basis of price. More specifically, it is shown that the only pure strategy Nash equilibrium outcome is characterized by monopoly commission rates. The main conclusion of the article is that future research on brokerage should be built not on price competition but on alternative forms of non-price competition.

Brokerage commission rates have long been an issue of debate in real estate literature. A number of studies have argued that the uniformity of the commission rate across different properties and regions is an indication of collusive behavior (e.g., Austin, 1973; Barasch, 1974; Owen, 1977; Bartlett, 1981; Yinger, 1981; Crockett, 1982; Wachter, 1987; and Jenkins, 1989). The exceptions to this line of literature include the empirical studies by Carney (1982), Goolsby and Childs (1988) and Sirmans and Turnbull (1997) who find non-uniformity in commission rates. Another line of research has claimed that free entry would force agents into non-price competition and derive profits to zero (Sirmans, Turnbull and Benjamin, 1991; and Miceli, 1992). None of these articles, however, offer a theoretical model that explicitly studies the way brokers set their commission rates.

Theoretical work on commission rates in real estate markets is very limited. Arnott and Anglin (1999) present a formal general equilibrium model of how the commission rate is determined. Their model reflects the externalities in the market and compares the equilibrium commission rate to the socially optimal rate. The numerical example of their model indicates that the socially optimal commission rate is only 2.8% when the observed rate in the market is around 6%. Schroeter (1987) and Carroll (1989) argue that uniform percentage commissions can promote welfare; clients who value brokerage services more highly offer to pay larger commissions and consequently receive more effort from the broker. However, both studies simply assume that competition in the industry will lead to zero-profit commission rates. Williams (1998) shows that, contrary to the claims of many studies on brokerage, uniform percentage commission rates do not produce agency problems between a broker and his/her clients. Another recent theoretical work by Mantrala and Zabel (1995) argues that the seller's option of skipping the broker and selling directly to buyers exerts competitive pressure on the broker's choice of the commission rate. Although their work proves that the direct selling option available to the seller constrains the broker's commission rate, such a constraint does not necessarily result in a competitive commission rate.

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