Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (6 page)

Nice story—except that it’s wrong. In fact, the widespread perception that a new car loses substantial value as soon as a buyer drives it off the lot is really just a myth, as we shall see.

In a market economy, if anomalies like the well-known lemon problem described by Levitt and Dubner occur, they inevitably create a financial incentive for entrepreneurs to solve them.
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Suppose you buy a car for $20,000 and decide for whatever reason to resell it quickly. Assuming nothing is wrong with the car, you have a $20,000 car with just a few miles on it, but according to Levitt and Dubner you can only sell it for $15,000 because buyers believe that people only try to sell a
new car so quickly when there’s something seriously wrong with it. What do you do? Do you really sell the car for a $5,000 loss?

Here is the real question: can you convince someone for, let’s say, $4,000 that there is nothing wrong with your car? What about for $500? Could you hire the car’s original manufacturer to inspect the car and certify that it’s in brand new condition? If you could do this for $500, and inform potential buyers about the certification in your advertisements, you could likely sell the car for the full $20,000, earning for yourself $19,500—not $15,000.

There are, in fact, lots of other possible solutions. For example, car manufacturers also allow warrantees to be transferred to new owners. Whether the warrantee is for three years/36,000 miles or five years/60,000 miles, a person who buys a lemon will not be stuck with it, even if he is the second owner. Furthermore, some places allow you to return a used car for a full refund. For instance,
CarSense
, a certified used car dealer in the Philadelphia area, offers full refunds for cars returned within five days of purchase.
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And of course, these resale companies want to maintain a reputation for screening out any problematic cars.

Luckily for us, the lemon thesis can easily be tested. I analyzed the prices of fifty-five certified used cars—all 2006 models—in the Philadelphia area, comparing the manufacturers’ suggested retail price (MSRP) for brand new cars with the certified used price and the Kelly Bluebook price.
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The Kelly Bluebook price “reflects a vehicle’s actual selling price and is based on tens of thousands of recent real sales transactions from auto dealers across the United States.”
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I looked at forty used cars that were less than a year old, all with about 15,000 miles on them. These were chosen to divine what used cars sell for when they are about a year old. An additional fifteen used cars had been driven less than 5,000 miles on them, averaging 3,340 miles.

One thing immediately became clear: used cars with only a few thousand miles on them sell for almost the same price as when new.
(See table on pages 38-39.) The certified used car price was on average just 3 percent less than the new car MSRP. And it was 3 percent higher than the new car Bluebook prices. The Kelly Bluebook further indicates that the private-transaction used car price was only 4 percent less than the new car Bluebook prices.
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One explanation for such a small discount on private transactions—in which buyers can’t even rely on a brand name dealer’s certification—is that manufacturer warrantees still protect buyers.

I called Kelly Bluebook to check if the sample I had was representative and was told that a study of all the cars in their sample would have yielded a similar result; there is surely no 25 percent drop in a car’s price as soon as you drive it off the lot. Even more damning, the price of these virtually new cars occasionally rises even above the MSRP. The Kelly Bluebook representatives claim that in order to maintain strong resale price values and prevent customers from feeling as if the dealer is taking advantage of them, manufacturers often ensure that dealers cannot sell their cars—even the most popular models—at more than the MSRP.

If the lemon thesis had been correct and “the seller would do well to wait a year to sell it,” as Levitt and Dubner claim, then used cars that are about a year old should not sell for much less than those with only a few thousand miles on them. But, indeed, they do sell for a lot less. Cars that are a year old have substantially lower prices. The certified used car price for these older cars was 14 percent lower than the new car MSRP and 8 percent lower than the new car Bluebook prices.

 

 

Some of us probably feel cheated in life. After all, many experts know more about whatever product or service we are buying from them than we do. Whether it is doctors or lawyers or auto mechanics, we seem to be at the mercy of specialists who have the ability to dupe us.

In
Freakonomics
, Levitt and Dubner portray America’s free market as a cut-throat environment in which consumers are constantly swindled by so-called experts. Habitually attributing economic anomalies to some kind of scam, the pair don’t seem to realize that market forces exist that punish dishonest behavior. Their distrust of the market is especially evident in their discussion of real estate agents. (Dubner once wrote an article on Levitt entitled “The Probability that a Real-Estate Agent is Cheating You.”)
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Levitt and Dubner are certainly entitled to their opinion, but in asserting that “the Ku Klux Klan [is] like a group of real-estate agents” because both groups use the “principle” of “fear” to take advantage of others, they push the rhetorical boundaries beyond what is tasteful.
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Are real estate agents really ripping off their own clients? Levitt and Dubner provide an anecdote by an anonymous Mr. K to illustrate how realtors cheat the sellers they represent by refusing to maximize the sale price of their homes:

It’s hard to see why real estate agents would deliberately depress bids. What can the agent gain from encouraging bidders to lower their offer? A lower bid means less money for everyone, including the agent. If agents are lowering the asking price solely to make a faster sale, then this is a poor example; the lower bid didn’t help sell the house any faster, since “K” was, in fact, willing to pay a higher price.

Assuming this story is completely true, a far more likely explanation for the agent’s actions is that she thought that the buyer was unwilling to make a higher bid. There is no way the agent could have known K was willing to bid up to $450,000, and perhaps she wasn’t sure
whether K would even bid at all. There are many other possibilities; maybe the seller was under pressure to sell quickly and there were no other likely buyers. Perhaps the agent knew that other houses in the neighborhood would soon go on sale and would depress the price of K’s home. Or, K may have simply been a good negotiator in this transaction. But that doesn’t mean the agent was chiseling her client for her own benefit.

Consider this true-life example. With a growing family a few years back, my wife and I were considering adding on two bedrooms to our existing house. But we were not sure and thought it might possibly make more sense to sell our house and buy a larger one. So we went for advice to an agent with the local Patrick D. Welch real estate office.

Now, if you believe Levitt and Dubner’s view of realtors as Klansmen-like swindlers who are out to make a fast buck, you would probably expect the agent to have recommended that we allow her to sell our house and find us a new one—a potential for two commissions. But instead, she told us, “I’d love to sell your house, but you’ll have a lot fewer hassles by putting on an addition.” She did not receive a commission or even charge a fee for her advice. And there is a market incentive for this kind of honesty—her actions enhanced her reputation and that of her employer as honest and reliable realtors. These reputations are extremely important for professionals such as real estate agents, who get many clients through recommendations from previous clients. And the importance of these reputations helps prevent experts from cheating their customers. If Levitt and Dubner could discover that the real estate agent selling the house to K was underselling her clients’ houses, odds are that other people have found that out, too.

Levitt and Dubner’s core argument is that realtors encourage their customers to “sell their houses too cheaply and too quickly,” while the agents themselves, when selling their own houses, leave them on the market longer and earn on average an extra $6,000-$10,000 on the sale of a $300,000 house. At first glance, this seems like a lot. But in
reality, the difference is only 2 to 3.3 percent.
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This indicates that if a realtor lives in a home for even just a few years before selling it, the extra return she gets on the sale for being a real estate agent is merely a little over 1 percent per year.

True, realtors typically earn a lowly 3 percent commission when selling someone else’s home but keep virtually all the revenues when selling their own homes, and this gives them a greater incentive to get the maximum price for their own abode. But one would still expect realtors to make more money selling their own houses simply because—as experts—they probably found a good deal when they originally bought them.
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Given all the time that realtors spend getting their license, learning the business, and spending every workday looking for bargains, a 2-3 percent higher price actually seems quite low. If anyone spent years looking at houses, they would also occasionally come across some great deals.

In addition, real estate agents know better than most people what improvements will boost a house’s value. While they do make these suggestions to their clients,
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realtors are more likely than their clients to take their own advice.

Finally, the cost for a real estate agent to sell her own home is probably significantly less than the cost of selling a client’s home simply because the realtor knows her own schedule. The agent does not have to coordinate with the seller on things like the timing of showing the house.

Similar advantages accrue in any profession with specialized knowledge; it’s not an indication that clients are being cheated. Don’t we expect doctors to obtain the top medical treatment for themselves simply because they know who the best doctors are and are better able to evaluate the medical advice they receive? Does this mean that patients who are not doctors are being treated unfairly?

Sellers of houses enjoy a competitive market among realtors. Realtors must compete against each other for clients based on their reputations,
commission levels, and their recommended selling price for a given house. Sellers also have the option of selling the house themselves, without an agent. In short, home owners who sell through a realtor do so because this allows them to get the best price for their house.