When shopping, we usually don’t have problems with price discovery. At the grocery store and most retail stores, we compare prices for similar products from several manufacturers, all conveniently lined up together on the shelf. For online purchases, we just click the “Compare to…” button. Our favorite shoes from Kinney cost $45 last time, now they are priced at $75. Ouch, but we did buy them four years ago, so maybe $75 today is understandable.
Manufacturers and resellers of consumer goods also conduct price discovery. They also do comparisons on store shelves. Even better, Pepsi and other consumer goods manufacturers know exactly how many 2 liter bottles of Diet Pepsi were sold at the local grocery store every day, and the corresponding price. Pepsi knows it can raise the price before the “big games” and holidays. We consumers know to shop a few days earlier to avoid the temporary markups.
For high-volume items price discovery is a science. For lower volume items and especially consumer-consumer transactions, price discovery becomes much more difficult and interesting. Consider very low volume transactions such as sale of a used car or a used house, or even large home appliances. In each case consumer-consumer transactions are common. How do the seller and buyer do price discovery and its partner, value discovery?
The Blind Auction
We just made an offer on a house in a resort / retirement area and I noticed considerable development in the price discovery process for real estate transactions. In the past decade house sellers and their realtors discovered the power of blind auctions. You may have bought a house recently and noticed the listing price seemed a little lower than you expected. Then, the selling realtor said, “We will be opening the offers next Monday, so get your very best offer in quickly.” The listing price was just a teaser. You knew you needed to bid over the asking price, but how much?
In a season of strong demand, this blind auction selling strategy is pretty difficult for a buyer to defend against. It resolves the “what’s it worth?” question for the seller, who does not want to leave any money on the table. In a conventional open auction, the bidders know the highest bid and even some information about other bidders. In the blind auction set up by selling realtors, the bidders have no information about other bids and bidders beyond anything the selling realtor may conveniently let slip in conversations with buyers’ realtors. Often the difference between the top few bids is considerable, suggesting that the buyer with the highest bid may have over-paid.
The Disappearing Offer
One simple defense against the blind auction is to submit a bid with a short expiration date, such as 24 hours, or even much less. This disappearing offer may work with a house that has been on the market for awhile and is not likely to attract competing offers. It probably won’t work with a house just listed at a price under market. The selling realtor can be confident that the house listing price, just under some reasonable market price, will attract many visitors, and a few offers.
The house we want was listed just one day before we saw it and the price may be just below some fair market value. The house has some peculiarities and its primary feature, for us at least, is a spectacular view of rock formations. Even better, it is secluded and abuts the national forest.
These intangible features are ideal for auctions and especially blind auctions. What is the value of a view of rock formations or a location bordering a national forest? The value depends upon the subjective opinion and assets of the buyer, not upon any objective comparison of square feet, number of bedrooms, and price per sq.ft. These factors make the blind auction particularly effective in this situation. How could we gain some leverage against the blind auction?
The Escalation Clause
Our realtor suggested using an escalation clause in our offer. The escalation clause is the next development in the continuing arms race of price discovery between real estate buyers and sellers. As you probably already know, the escalation clause literally constructs an automatic auction among buyers, even those buyers who did not use the escalation clause in their offer. A buyer submits an opening bid, a maximum bid, and a bidding step. Buyers not using the escalation clause simply submit an opening bid, which becomes their maximum bid.
When all bids are opened, the sellers and their realtor note the two highest maximum bids. The selling price is the second highest bid plus the step size of the highest bidder. The winner is the highest bidder.
The escalation clause requires an honest selling realtor because the bidders are not present to watch the process. So buyers’ realtors require that, if the escalation process is used to determine the final price, the seller’s realtor must show the second highest offer to the winner. This simple check turns out to be a pretty good protection because the interests of the seller and the seller’s realtor are not well aligned on the transaction.
Oddly, the interests of the two realtors may be fairly well aligned. Both realtors want a quick sale, at a reasonable price, with no problems after the sale. Realtors live and work daily in the local real estate market, so they know each other and their reputations. Sellers and buyers are just visitors in the local real estate market, with much less interest in their own reputations in the market.
Gaming the Escalation Clause
The increase in commission to the realtor is usually relatively small. For a house sold at $1 million, the commission for each realtor may be 2.5% net, or $25,000. If the escalation clause drives the winning bid up to $1.2 million, the seller has a strong incentive to game the system. The selling realtor receives only an additional $5,000, which is nice but not very significant. While the sellers may be willing to consider some chicanery to gain an additional $200,000, the selling realtor most likely will not risk her license and career for $5,000. The seller has relatively low risk and high reward while the seller’s realtor has a low reward and much higher risk.
Even without chicanery some information leakage, either accidental or intentional, is possible. The selling realtor can indicate to a preferred buyer that their bid is not the highest, or even let slip the actual highest bid. Since the seller is not obligated to take the highest bid any improvement in the bid of the preferred, or preselected, buyer is more cash in the seller’s pocket.
With intentional leakage and little chicanery, someone may invite a straw bidder to submit a bid just under the maximum escalation price of the winning bid. The winning buyer still wins the property, but the price is much closer to their maximum price. Either the seller or seller’s realtor can use this technique without the knowledge of the other. Even so, the seller has some risk and the selling realtor faces a high risk with a relatively small reward. With the straw bidder in on the scam, the risk increases.
Other, possibly better, methods of cheating will be developed. Realtors will even develop perfectly legal methods to reduce the effectiveness of the escalation clause. Evolution works everywhere, in everything.
The Rest of the Story
A few days from now we will know the answer regarding our offer with the escalation clause. Buyer’s remorse looms with either outcome. We set our maximum escalation price so that we will be happy, or at least at peace, with either outcome. Or so we tell ourselves.
One thought on “Price Discovery”
Wow, I had no idea you put quite so much thought into the expiration or escalation clause of your offer!
We struggled with price discovery at my last gig too, interestingly, but for very different reasons, since there’s no open market/exchange for voluntary carbon credits, and they’re not (yet) truly equivalent commodities. Whee!