Exclusive Agency
Walking the fine line of transaction cost mitigation
Though perhaps unpopular, real estate agents perform an important service in the housing market — they minimize transaction costs. This is especially true as the practical knowledge of legal and financial processes required to facilitate the exchange of a property has increased over time. No longer is it common for a house to remain in the possession of a single family for generations, where a child grows up in a house, builds a family in that house, inherits that house, and then the cycle repeats.
Most of the time, real estate is transacted between strangers.
The facilitation of real estate transactions between strangers relies on both expectations and agents. There exists a list of expectations that all parties involved in a real estate transaction maintain, most of which will hold in court. Expectations such as the smooth exchange of money and property, timeliness, remediation of damage before possession, and more. Both parties hold one another accountable to expectations such as these and would do so with or without a realtor provided the court system were sufficiently quick and cheap or the parties held mutual trust.
The court system is neither quick nor cheap, however. And the majority of real estate transactions occur between two parties who have never met and, therefore, hold no mutual trust for one another.
Here, we have a simple example of Ronald Coase’s insight from The Problem of Social Cost. In an ideal world, expectations between buyer and seller will be clear and obvious. If both parties have trust that the other will meet these expectations, then there will be no disagreeable situations — most every transaction will run smoothly and those that don’t will see issues remedied swiftly as the parties solve their own problem.
Ex.) If money was not transferred sufficiently quickly and trust is high, the buyer and seller may negotiate some inconvenience payment or other mutually acceptable remediation.
Alternatively, if there is very little trust in this situation, but the court system operates swiftly and in a manner aligned with these expectations, the buyer and seller will still opt to avoid the legal process altogether in the event of a disagreement.
Ex.) If money was not transferred sufficiently quickly and trust is low but the court system is predictable, the buyer and seller may negotiate some inconvenience payment or other mutually acceptable remediation on their own to avoid legal fees and time spent in court as each party already knows what the court will decide.
The first case is the ideal scenario. The second is a less ideal scenario, but one which results in the same outcome — courts are not consulted, and parties negotiate on their own for mutually beneficial outcomes.
The escalation of these cases relies on transaction costs. In the first case, we must assume that each party is equally advantaged or disadvantaged such that there are no power discrepancies or entitlements tilting the scales. If these are present, then the second case becomes preferable. When the court system is swift and predictable, these advantages or disadvantages matter little — each party wishes to mirror what the court would decide without paying legal fees as each party knows what the court will decide.
Let us now imagine a third case. For this case, expectations within a real estate transaction are not clear or obvious and the court system is both costly and time-consuming. Here we can see the power of the real estate agent.
Neither party of the transaction trusts the other and neither fully understands or is aware of the expectations upon them and their counterpart in the transaction. Of course, there are also power discrepancies and entitlements that may skew negotiations away from mutually beneficial terms, despite this, both parties face a strong incentive to not go to court, as the legal process is time-consuming and costs a significant amount of money.
But rather than seek a public policy response, buyers and sellers utilize real estate agents. These agents are experts in the transacting of property, they are fully aware of the expectations of these transactions. These agents trust one another to exercise this expertise, and the buyers and sellers trust the agents to act fully on behalf of their interests. With expectations now clear and trust established, the court system would be avoided even if the cost to utilize it were low (see case #1).
What’s happened in this third scenario showcases the function of transaction cost mitigation. In a world with significant transaction costs, real estate agents circumvent the problem by leveraging expertise to establish trust between buyer and seller by proxy. Pushing the housing market generally to its best outcome — smooth exchange without involvement of the legal system.
