Monday, September 04, 2006


In deals where an agent or broker acts for a principal, such as real estate, the agent commonly charges a straight percentage as commision for the deal.

This supposedly aligns the interests of the agent (service provider) with the interests of the principal (service consumer). If you reduce the commission rate, the agent may have less incentive to get the best possible deal on your behalf. The New York Times ("The Last Stand of the 6-Percenters?") reports a number of startup real estate brokers who are offering discounts. Established brokers want restrictions, which the startups are calling "a thousand tiny shackles on innovation". Adam Shostack avers that he would prefer to pay a higher rate for a broker that negotiates a better deal.

Obviously, if the broker works harder and gets you an extra $50,000 on selling your house, you should be happy to pay her a decent percentage of this. And perhaps the extra commission will help fund (or justify) innovation, making the more expensive brokers more efficient and effective than the cheap ones. Obviously it's a false economy to use a cheap broker and end up with a lousy deal.

But this doesn't reflect some important dynamics of the service industry.

Firstly, there is the startup dynamic. A service provider trying to gain market share might possibly work harder and/or innovate more, to provide a better service for less money. Established players aren't always the most energetic or innovative.

Secondly, a straight commission does not truly reflect effort or value. Suppose a house is actually worth $450,000, and might reasonably sell for anything between $400,000 and $500,000. But it requires twice as much time and effort for the broker to get the higher figure. Why should the broker put in twice as much effort to earn 25% more money? Makes much more sense for the broker to persuade the seller to accept a lower offer, and quickly move onto the next opportunity.

In the book Freakonomics, there is some evidence that this is exactly what brokers do. Because when they are selling their own houses, they keep them on the market for longer and get better prices, than when they are selling houses for their clients.

So the traditional service pricing does not reflect the effort expended by the service provider. But does it reflect the value-added received by the service consumer? Not really - if I wanted to sell my $500,000 house for less than $400,000, I might put an advertisement into the local paper myself and do without the broker altogether.

So the broker only really earns her fee on the last 20% of the value.

So here's my solution. Instead of paying a regular commission on the whole value of the deal, pay nothing (or next-to-nothing) for the first 80% of the deal, and a much higher commission on the last 20%.

More generally, we need to find service pricing that aligns the interests of the service provider with the interests of the service consumer. (This is sometimes called incentive-compatibility). Linear pricing may be the simplest, but it may not be the most economically efficient.

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