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The Incentive Effects of Flat-Fee and Percentage Commissions for Real Estate Brokers

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This paper analyzes the incentive affects of flat-fee and percentage commission systems from the perspective of the economic theory of agency. Under a plausible set of assumptions the systems provide equivalent incentives. However, the relative desirability of the two systems depends upon the pricing strategy employed and factors specific to the individual. In general, neither system perfectly aligns the interests of the agent with those of the property-owner. A surprising result of the analysis is that the optimal listing price when an agent is employed may be below the first-best price. The first-best price, or residual maximizing solution to the principal-agent problem from the perspective of the property-owner, is the solution that would occur if the agent's interests were perfectly aligned with those of the principal. This study suggests that the use of a percentage versus a flat-fee commission may be due to information costs rather than price discrimination on the part of brokers. Copyright American Real Estate and Urban Economics Association.
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... More broadly, this paper contributes to studies on the compensation structure and contract design between a principle and agent. For example, while agents may exert greater effort in market transactions for themselves than they do for others, the findings provide supportive evidence of the benefits of correctly crafted incentives discussed in the compensation/management literature (e.g., Holmström, 1979;Yinger, 1981;Zorn and Larsen, 1986;Holmström, 2017). Furthermore, the findings I present introduce a new puzzle for real estate research. ...
... Moreover, data on non-MLS rental contracts are costly to collect, which strains the opportunity to compare and contrast the performance of rentals arranged by owners vs rentals arranged by brokers in a similar manner that Hendel et al. (2009) evaluate the value of real estate agents in the ownership market. However, if the agent's compensation is a fixed amount and agents generally use an industry norm to define the commission rate, the agent may not undertake the additional search effort when he or she does not own the property since the additional search effort will not be compensated (Zorn & Larsen, 1986). In contrast, when the agent rents her own property, the additional search effort makes economic sense and may choose to list and subsequently lease the rental property at a higher price, since it generates a positive net benefit for the agent-owner. ...
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