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I n t r o d u c t i o n The active residential broker has a significant information advantage over prospective home sellers. It is presumably due to this advantage that sellers find it advantageous to hire brokers. Most commonly, agents are compensated under a fixed-percentage commission arrangement. This contract has been shown to poorly align incentives and to distort risk sharing. We propose an alternative system that, given homogeneous beliefs and time preferences, aligns the interests of sellers and brokers. The alternative system also addresses the ‘‘listing-only’’ problem, often ignored in the literature. In our proposed system, the agent purchases the property from the seller. At the same time, the home seller sells to the agent a put option on the property. The put option gives the agent the right to convey the title back to the home seller at the original purchase price at any time during the listing period. This helps ensure the former owner’s cooperation in the agent’s marketing effort. We show that this arrangement provides first-best incentives to the agent, while maintaining proper incentives for the seller. A discussion of the merits of this proposal relative to current institutional arrangements is also provided. The article is organized in the following fashion. First, a brief review of the relevant literature, followed by a formal analysis of optimal effort and listing price choices under a dealer system and the fixed-percentage commission structure. Next, a proposed alternative market structure is presented. A summary and conclusions are presented last. 5 0 J a r e s , L a r s e n a n d Z o r n L i t e r a t u r e R e v i e w In the last twenty years, a substantial literature has developed with regard to the principal-agent problem. The familiar principal-agent framework has been used to analyze the efficiency of existing contracts as well as to guide the design of new contracts in the real property market. Zorn and Larsen (1986) show the fixed-percentage commission contract fails to provide first-best incentive alignment. Anglin and Arnott (1991) provide an extensive analysis of the terms of the brokerage contract. They find that the fixedpercentage commission contract performs poorly by failing to allocate risk and to provide agent incentives efficiently. The two distortions with respect to the firstbest solution are that the agent expends less effort and bears greater risk. In addition, they find that the optimal contract with a risk-averse principal and agent implies a marginal remuneration rate that exceeds the remuneration under the firstbest contract. Alternatively, Arnold (1992) describes certain conditions under which the standard fixed-percentage commission contract can provide first-best results. Miceli (1989) and Geltner, Kluger and Miller (1991, 1992) also consider the efficiency issue. Geltner, et al. find that an optimal duration contract can help align incentives in the effort dimension. However, they also find that contract duration can further distort incentives in the informational dimension. In short, they find that effort conflicts with regard to selling intensity are virtually non-existent near contract termination, while incentive conflicts with regard to pricing advice become much more extreme. Yavas (1995) further analyzes the current fixed-commission contract, however his important extension recognizes the seller’s effort. He provides several examples of seller effort including property maintenance and flexibility to showings and open houses. If seller’s effort is further defined to include occupation of the property, Larsen’s (1996) finding that occupied houses sell more rapidly than those that have been vacated is important. Because the evidence on incentive alignment under the fixed-commission contract is mixed, it is natural to question the persistent domination of this arrangement in real estate markets. Anglin and Arnott (1991) argue it favors established agents and precludes contractual diversity. Levmore (1993) notes that transaction costs can inhibit the adoption of an alternative framework. For instance, he discusses a progressive-commission structure whereby the agent’s marginal return increases as the sale price increases. Unfortunately, a friction arises such that it can be difficult to negotiate the ‘‘trigger’’ prices at which the agent’s marginal earnings increase. The answer to the fixed-percentage commission contract’s survivability may not lie solely in its impact on a single agent-seller relationship. Carroll (1989) argues that the traditional structure promotes market efficiency by equitably distributing I n c e n t i v e S y s t e m F o r R e a l E s t a t e A g e n t s 5 1 J R E R V o l . 2 0 N o . 1 / 2 – 2 0 0 0 an agent’s effort among homes the agent is attempting to sell. In a similar context, Levmore (1993) suggests that uniform commission contracts exist partially to eliminate principal (seller) competition. He asserts that if non-uniform contracts existed, agents would disproportionately devote their effort to the property promising the greatest marginal return. It has also been suggested that the lack of heterogeneity in real estate contract arrangements provides direct evidence of anti-competitive behavior among brokers. It is argued, that to perpetuate an anti-competitive environment, real estate brokers collectively maintain the fixed-percentage contract. Shroeter (1987) and Knoll (1988) point out that the standard commission structure can be consistent with competitive behavior if the opportunity cost to the seller increases with the value of the home. This argument is plausible because owners of more expensive homes typically earn larger incomes, and interest expense on home loans increases linearly with price. Although these issues are important, we focus on the contract’s incentive effects between a single seller and agent. O p t i m a l C h o i c e u n d e r t h e F i x e d P e r c e n t a g e C o m m i s s i o n S t r u c t u r e We first view the problem assuming that it is possible for the property owner to sell the property to a dealer who operates in a competitive environment. The dealer bids the value-maximizing amount V. This value reflects the expected time it will take to sell the property and the cost incurred. Assuming the existence of a dealer allows us to compare this ideal solution with the percentage commission system and with our suggested alternative. We assume that in each period the probability of selling the property, , is a function of effort and other costs, c, the dealer incurs. We assume all costs are subsumed by c. The probability of sale is constant because we assume that the effort and pricing decisions are made at the initiation of the listing contract and maintained throughout. This assumption is consistent with empirical evidence. Belkin, Hempel and McLeavey (1976) find that properties in a properly priced submarket have an equal probability of sale in the next week regardless of how long they have been on the market. For simplicity, we assume that the broker is risk neutral. The most the dealer would bid is: V P c (1 )( P c)/(1 r) 2 2 (1 ) ( P c)/(1 r) , (1) where r is the time discount factor. Because the probability of a sale is always less than one, Equation (1) has an infinite number of terms. The expected time to a sale is equal to (1 )/ . Noting that (1 )/(1 r) must be less than one, Equation (1) can be simplified to the following finite form: 5 2 J a r e s , L a r s e n a n d Z o r n V ( P c)(1 r)/(r ). (2) Once the dealer has purchased the property from the seller, it is self-optimal to exert the value maximizing effort. We assume that the dealer must set a price P such that any prospective buyer may either accept or reject the property at price P. Differentiating with respect to effort, we obtain: