1076
[Journal of Political Economy, 2003, vol. 111, no. 5]
! 2003 by The University of Chicago. All rights reserved XXXXXXXXXX/2003/ XXXXXXXXXX$10.00
Can Free Entry Be Inefficient? Fixed
Commissions and Social Waste in the Real
Estate Industry
Chang-Tai Hsieh
Princeton University and National Bureau of Economic Research
Enrico Moretti
University of California, Los Angeles and National Bureau of Economic Research
Real estate agents typically charge a 6 percent commission, regardless
of the price of the house sold. As a consequence, the commission fee
from selling a house will differ dramatically across cities depending
on the average price of housing, although the effort necessary to
match buyers and sellers may not be that different. We use a simple
economic model to show that if ba
iers to entry are low, the entry
of real estate agents in cities with high housing prices is socially in-
efficient. Consistent with our model, we find that when the average
price of land in a city increases, (1) the fraction of real estate
okers
in a city increases, (2) the productivity of an average real estate agent
(houses sold per hour worked) falls, and (3) the real wage of a typical
eal estate agent remains unchanged. We cannot completely rule out
the alternative explanation that these results reflect unmeasured dif-
ferences in the quality of
oker services. However, we present evi-
dence that as the average price of housing in a city increases, there
is only a small increase in the amount of time a buyer spends searching
We thank Ben Bernanke, David Card, Angus Deaton, Harold Demsetz, William Easterly,
Ray Fisman, Gene Grossman, Karla Hoff, Peter Klenow, Phillip Leslie, Steve Levitt, Da
en
Lubotsky, Chris Redfearn, Scott Susin, John Wallis, and a referee for useful comments.
We gratefully acknowledge partial financial support from the Center for Economic Policy
Studies at Princeton University and the Academic Senate at UCLA. Hsieh worked on parts
of this project while visiting the World Bank’s Development Research Group, which he
thanks for its hospitality. This paper previously circulated under the title “Uncovering
Rent-Seeking and Social Waste: A Parable from the Real Estate Market.”
free entry 1077
for a house, and the average time a house for sale stays on the market
falls.
I. Introduction
There is a widespread view that ba
iers to entry of new businesses are
harmful and that society would benefit from the removal of such bar-
iers. Yet it has also long been known that under certain conditions,
free entry may actually be socially wasteful (see Spence 1976a, 1976b;
Dixit and Stiglitz 1977; Mankiw and Whinston XXXXXXXXXXThe basic idea is
that while the competition due to new entrants may lower prices, en-
trants also steal business from existing firms, and this latter effect could
esult in a socially inefficient overspreading of output. The net gain
from market entry thus depends on whether the price competition effect
outweighs the business-stealing effect.
Yet, despite the possibility that market entry may be socially inefficient,
there is little empirical work that measures the net social gains from
market entry.1 In this paper, we fill this gap by measuring the effect of
entry in the U.S. residential real estate
okerage market. Two char-
acteristics of the real estate industry make it particularly interesting.
First, there appear to be few ba
iers to entry in the industry. Second,
in the period under consideration in this paper, the
okerage com-
mission paid to the real estate agents handling the sale of a house is
almost always stated as a fixed 6 percent of the selling price of the house.
What is particularly surprising about the apparent uniformity of the
commission rate is that it implies that a real estate agent’s commission
from selling a house will differ dramatically depending on the price of
the house, although the effort necessary to sell an expensive house may
not be much different from that required to sell a cheaper home.
The main argument of this paper is that if in fact commission rates
are fixed, then the absence of ba
iers to entry results in socially wasteful
entry by real estate agents in cities with high housing costs. Consider,
for example, two cities—Boston and Minneapolis—that are similar in
most dimensions except in the cost of housing. In 1990, the price of a
typical house in Boston was roughly twice that in Minneapolis.2 With a
fixed commission rate, the
okerage fee from selling a typical house
in Boston was therefore twice that of a similar transaction in Minne-
1 The only work that we are aware of is Be
y and Waldfogel’s XXXXXXXXXXwork on radio
stations in the United States. There is a literature on the effect of entry on firm size and
pricing behavior (see, e.g., Bresnahan and Reiss 1991), but this literature does not focus
on the potential losses due to the business-stealing effect.
2 According to the 1990 census, the average price of residential housing was $216,231
in Boston and $100,504 in Minneapolis.
1078 journal of political economy
apolis. If this is all there is to the story, real estate agents in Boston
would simply earn twice as much as their counterparts in Minneapolis.
Real estate commissions would simply be a transfer from home sellers
and home buyers to real estate agents, and the deadweight loss from
the fixed commission in Boston would probably be small, especially if
the demand for real estate transactions is relatively price-inelastic.
However, because there is relatively free entry into the real estate
usiness, an average real estate agent in Boston does not earn twice as
much as an agent in Minneapolis. Because the commission from selling
a typical house is twice as high in Boston as it is in Minneapolis, there
are more real estate agents in Boston seeking these high commissions,
although the total number of homes sold each year is actually larger in
Minneapolis. Consequently, the average real estate agent in Minneapolis
is much more productive than a typical agent in Boston, selling 6.6
houses each year in Minneapolis as compared to an average 3.3 houses
a year in Boston.3
One could still argue that there is something fundamentally different
etween Boston and Minneapolis, that the effort necessary to sell a
house in Boston is simply twice the effort necessary in Minneapolis.
Perhaps the dense u
an structure or the older age of dwellings in
Boston makes it harder for
okers to sell houses, or perhaps descen-
dants of Irish Catholics are more finicky about their housing than de-
scendants of Germans and Scandinavians. However, it has not always
taken twice as many real estate agents to sell a house in Boston as in
Minneapolis. Although the productivity of real estate agents in Min-
neapolis was twice that in Boston in 1990, the difference was much
smaller in 1980. In 1980, a typical real estate agent in Boston sold six
houses, whereas her counterpart in Minneapolis sold seven homes.
What accounts for this change? From 1980 to 1990, housing prices
doubled in Boston, whereas the average price of housing in Minneapolis
emained unchanged. Since the commission rate is fixed, the commis-
sion from selling a house in Boston increased from 1980 to 1990 and
thus attracted many people into the real estate business in Boston seek-
ing to earn these fees. By 1990, the number of real estate agents in
Boston had roughly doubled. And since the number of houses sold in
Boston in 1990 had roughly remained unchanged, the productivity of
an average real estate agent in Boston in 1990 had fallen to almost half
of what it was in 1980.
The tragedy of this outcome is that despite the fact that home sellers
in Boston pay twice as much to real estate agents as in Minneapolis,
eal estate agents in Boston are no better off than in Minneapolis, no
3 We see a similar productivity gap when we measure productivity as houses sold per hou
worked: XXXXXXXXXXin Boston and XXXXXXXXXXin Minneapolis.
free entry 1079
Fig. 1.—1980–90 changes in the productivity of real estate agents (houses sold in the
city/hours worked) and changes in the cost of housing. Each bu
le represents a met-
opolitan area. The size of the bu
le is proportional to the metropolitan area population.
There are 282 metropolitan areas. Data are taken from the 1980 and 1990 Census of
Population and Housing.
are they better off than their counterparts in 1980. The higher com-
missions in Boston are simply dissipated, wasted through the entry of
eal estate agents seeking to earn these higher commissions, agents who
could be profitably engaged in other activities.
In short, this comparison of Boston and Minneapolis suggests that
we look for the following three pieces of indirect evidence of socially
wasteful entry by real estate agents. Specifically, if commission rates are
fixed and if real estate agents dissipate higher commissions in cities with
high housing costs through entry, in cities with high housing prices, we
should see (1) more real estate agents (relative to the city’s labor force),
(2) lower productivity (sales per agent or sales per hour worked), and
(3) real wages of real estate agents that are no higher than in cities with
low housing costs.
In this paper, we find strong support for all three conjectures, in a
cross section of 282 cities and also when considering changes across
these cities from 1980 to 1990. These results also hold true when we
account for part-time real estate agents. As a preview of our empirical
evidence, consider the scatter plot of the change in the log productivity
of an average real estate agent in a city from 1980 to 1990 against the
change in the average log price of housing (fig. 1). This figure suggests
that a 1 percent increase in average housing prices in a city results in
1080 journal of political economy
a 0.7 percent decline in
okers’ productivity, which we interpret as
indicating that 70 percent of the higher commissions in high–housing
cost cities translate into social waste. However, an alternative explanation
is that the higher commission in high–housing cost cities may reflect
the possibility that a
oker has to spend more time matching buyers
and sellers in such cities. For example, expensive houses may have id-
iosyncratic features. And even when differences in housing prices are
entirely due to the price of land (rather than housing quality), home
uyers in expensive cities may take more time searching and visit more
houses before making a decision. Therefore, the co
elation between
housing prices and the productivity of realtors may reflect differences
in the quality of the service provided by realtors.
Although we cannot completely rule out this interpretation, bear in
mind that the evidence presented in figure 1 considers changes ove
time, which abstract from permanent characteristics of cities that might
also reflect the difficulty of matching buyers and sellers in a given city.
In addition, we also provide four pieces of evidence that are inconsistent
with this interpretation. First, we condition