Tuesday, February 07, 2012

Househunters Meets Econ

A famous quip suggests that if you could teach a parrot to say "supply and demand," he could replace 90% of the world's economists. However, what economics is really about is analyzing the decisions people make in the face of scarcity and uncertainty. While the supply-and-demand model does have a wide variety of applications, it also comes with a laundry list of assumptions that give the model its power and tractability. One of these assumptions is complete information about the prices and quality of various goods. But one thing is for sure—in the housing market, there is certainly imperfect information about current and future market conditions.

For example, last week I found myself in an interesting predicament while house hunting. I was faced with two options: I could make an offer on a house currently on the market (going forward we’ll call this House A), with the belief that it was priced-to-sell and thus would likely be unavailable in the coming weeks. Or I could wait a month for more houses to come on the market, thus foregoing House A and incurring additional costs, like the effort to find new houses on the market and travel time to look at houses. This situation is exactly the type of scenario studied by search theory economists.

Search theory is a branch of economics that models markets with search frictions. In this case, “frictions” are the unknowns about what kinds of houses will come on the market in the coming months. You are faced with the choice of either accepting the good you’ve found today (House A) or throwing that choice away and paying a cost to find another choice tomorrow (House B). With some standard assumptions regarding utility and the distribution of houses on the market, the optimal way to shop is to use a reservation strategy; this means that you continue to shop until you find a house that makes you equally or more happy than that of the “reservation house”. This is the house that makes you exactly indifferent between continuing to search and buying it.

Thus, you can imagine my excitement surrounding house hunting. Not only is it fun to peruse the web and schedule showings, but house hunting is a great example of where supply and demand falls short, making room for more appropriate economic models like search theory. In most cases, consumers don’t know with certainty where goods can be found, how much they cost, and if they’re available; rather, they must spend time and money searching for these goods. When people ask me what kind of economics I like to study, my typical response is “the economics of shopping.” Search theory is simply the economic tool I use to describe it.

Discussion Questions:

1. How would you expect the time you have to search for houses to factor into the characteristics of your reservation house? In other words, do you think your level of pickiness will change if you had 3 months left to search versus 12 months?

2. Suppose that you didn’t have to worry about losing a housing option if you decide to search another day. Search theorists called this having “recall” over previous draws. How do you think this affects your “reservation house” if you’re searching over an infinite time period. How about a finite time period such as 12 months?

3. How has the internet alleviated search frictions in the housing market?

4. What other markets might be better explained using search theory as opposed to the standard theory of supply and demand? Why?

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