Home Prices – Value Gap

Sometime back I wrote about why homeowners list their prices at higher prices than the comparable sales prices in their localized market.  I theorized it is due to endowment effect and ignoring opportunity costs. It appears now the list prices are starting to reflect the market rather than what the homeowners value. Here is a report on MarketPlace:

Chris Mayer tracks real estate at Columbia’s business school. He says reality is finally sinking in for home sellers.

CHRIS MAYER: There’s an initial loss and people are looking at this and saying, but God, I paid $400,000 for the house. I’m just not going to sell it at $300,000. And over time, people realize that $400,000 isn’t coming back and they adjust their expectations.

According to the report. quarter of all homes that are for sale have dropped in prices at least once.   Behavioral economists say, homeowners are going to feel pain every time  they drop prices that is comparable in magnitude to the pain felt with the first price drop.

What does it mean for those who have their house on the market? Emotionally,  it is better for them to calculate more accurately the required price drop and do it once rather than do it in steps.

Business Built On Endowment Effect

Endowment Effect,  introduced by Thaler, states that people tend to value things they own more than they are valued by the market. Hence people are reluctant to let go of things they own at the market price and end up accumulating them. The New York Times magazine profiles  the business that is build on this, Self-storage. People are not rational automatons, they are not aware of sunk costs nor are they capable of doing net present value calculations of multiple options. They cannot tell the monetary difference between storing their wares in self-storage vs. selling them now in garage sales at the prices the market is willing to pay.

Clem Tang, a spokesman for Public Storage, explains: “You say, ‘I paid $1,000 for this table a couple of years ago. I’m not getting rid of it, or selling it for 10 bucks at a garage sale. That’s like throwing away $1,000.’ ”

People end up paying $100-$200 per month for storing things that will not even cover the rent if they were to be sold off. The result is a thriving business – self-storage  that adds negative value to most of its customers. The question is will we see a return to rationality due to current economic conditions?

Other related articles:

  1. Endowment Affect in Wendy’s commercial
  2. Theory Behind Home Staging
  3. Pricing Garage Sale

Gourmet Airline Food Sets High Reference Price

When US Airways tried to charge $1.99 for soft drinks it faced customer backlash and ended up rolling back to free drinks. As my team’s consumer behavior experiment showed, the plan would have succeeded if they had improved customer reference price before charging for drinks. In our experiment we found that the presence of high priced options, like $4 Evian water, increased customer acceptance of $1.99 for ordinary bottled water. Today I saw an article in The Wall Street Journal that airline food is going gourmet.

One of the best-selling items, Delta says, is a $6 fruit-and-cheese plate with smoked Gouda, Havarti and Derby cheeses paired with grapes, pecan halves and dried apricots.

For $10, American serves you a chicken Carver sandwich, bag of potato chips and a soft drink (still offered free by the airline). Another offering: the popular nut mix American serves to first-class passengers has been packaged for coach customers, at $3 per serving.

On Hawaiian, passengers can get free manicotti with chocolate cake, or pay $10 for Caesar salad with grilled chicken or satay chicken in vermicelli noodles. The best-seller is a sushi bento box with California rolls, edamame and teriyaki chicken.

Airline sales data show  about 4-6% of passengers buy these premium products. The may not look much but the opportunity is in charging for the basics for the rest of the passengers. The high priced premium offerings may not be a profit source  but their presence help to improve customer reference price and hence their willingness to pay for the freebies. On a plane with 130 passengers, premium items priced at $10  bring in a revenue of $80 but even if only 50% of the  passengers buy the $1.99  soft drinks, that is an additional $130 in revenue.

The true impact of the premium priced airline gourmet food is in improving customer reference price enabling further unbundled pricing.

Amazon.com – Managing Reference Price

It is not news when I say that Amazon.com offers free shipping on orders of $25 or more. But there are two very interesting things I see in how they implement that offer:

  1. The free shipping option is a less convenient option. The offer states that it will take 5-7 business days compared to 3 business days for the next lowest priced standard shipping option. The shipping charges are not different but  Amazon manages customer perceptions of the service by signaling that it is the slowest of all options. Whether or not it would take 5-7 days is immaterial.
  2. When a customer checks out the check out page very clearly shows the shipping charges  and subtracts the same from the total price. This is about managing customer reference price for shipping. Amazon wants to say that shipping is not really free and signals the customers that they would have paid , for example $5.47, if not for the the promotion.

This is about managing customer perception and reference price. They do not want the customers to think that price for shipping is $0. Maintaining a non-zero reference price  enables amazon to start charging for this lowest option when they need to without causing customer backlash (like the one airlines faced with drink fee).

Slow decline of Home Prices

Shiller (of Case -Shiller index) wrote in The New York Times about why home prices fall slowly instead of crashing and why the prices may continue to fall. This is a great explanation of the averages and the reasons for slow decline. Two questions occur to me:

  1. Why does a homeowner start with a very high list price even though the market price (based on comparable homes) is lower?
  2. Why are homeowners willing to let go an offer only to settle later for the same or lower price?

The reason for the high list price can be attributed to endowment effect. People tend to value things they own more than the things they do not. This is nicely demonstrated in a video by Dan Ariely. There is considerable emotional connections that get translated into higher utility and hence a higher valuation. In addition to this people do not consider opportunity cost of carrying the home for longer time. This results in initial high priced listing despite the fact that comparable houses in the neighborhood have been in the market for a much longer time and are currently priced lower than this house. Unfortunately buyers do not share the same emotional value hence houses end up sitting in the market longer.

The reason for rejecting reasonable offers during the initial days only to settle for same or lower price later is due to mental accounting that ignores the opportunity cost of carrying the home longer. Opportunity cost here includes additional mortgage payments, carrying costs and most importantly lost revenue from capital tied up in the house. Even if they considered opportunity costs, homeowners overestimate the chances of getting better offer and underestimate the time they need to wait for such an offer. Due to  high initial price, a low offer will also look substantially lower.

The net result is prices not reflecting what the market is willing to pay. Hence the slow decline of home prices.

Presence of Vice Products Increases Utility from Virtue Products

On a sunny afternoon you just finished your run and is hungry for a snack. Now consider these two scenarios

  1. You walk by a fruit stall that sells only fruits and you buy an apple
  2. You walk by a fruit stall that sells Snicker and other chocolate bars as well and you still buy an apple

In both these scenarios, which one of the two will you feel more virtuous? According to Dhar and Wertenbroch, you will feel  more virtuous in the second situation.

Selecting an unappealing virtue from a choice set that also includes tempting vices provides a positive self-signal (highlighting one’s ability to resist temptation) that enhances the utility of consuming the virtue

Utility from consuming the virtue when a choice is available is more than that when virtue was the only option available. Since consumer’s utility translates to their willingness to pay, can a marketer apply the findings of Wertenbroch and Dhar to increase perceived value of their virtue products and hence be able to charge higher price premium? Yes,  here are a few applications for this finding:

  1. For the said two stores, the one selling both candy bar and apples can price the apples more than the other stores and the customers would gladly pay for it.
  2. For a restaurant selling fresh green salads, offering a really greasy and fatty appetizer or entree  in the menu will enable it to price the salad at a higher price than it would have been possible with all healthy options. This is one reason why McDonalds is able to charge  premium prices for its salad options.
  3. A broader example is green products, these qualify as virtue compared to regular products. Are customers willing to pay a higher price for green products? In a study done by Yale forestry department it was stated that half the people surveyed they were willing to pay a 15% price premium for green products. A marketer cannot take these results to imply that customers will choose green products at the point of purchase. But we infer from Wertenbroch and Dhar’s study that a marketer is better off, in terms of profit maximization, offering regular products alongside green products instead of just green products.

Take the most recent story from NYTimes on how chickens are killed before they are processed.

Two premium chicken producers, Bell & Evans in Pennsylvania and Mary’s Chickens in California, are preparing to switch to a system of killing their birds that they consider more humane.

When customers see these benignly killed chicken next to regularly killed chicken, their willingness to pay for the former is likely to be higher than that for the latter.