Oligopolistic competition between home builders

An article in the WSJ documents how home builders are dealing with the weakening market:

Slow sales have prompted builders and some individual sellers to offer unusually generous incentives to agents whose clients buy a home. Sellers normally pay the buyer's agent 2% to 3% of the home's price. Now many are offering thousands of dollars or other rewards, such as travel vouchers, on top of the normal commission.

Such incentives have long been used to sell some homes. But they have proliferated and become more generous recently as a glut of properties on the market makes it harder to sell homes. "These guys are desperate," Ivy Zelman, a Cleveland-based housing analyst at Credit Suisse Group, says of home builders.

Although there are no national data on the practice, real-estate agents and builders agree that incentives have become much more widespread in recent months, especially in areas such as Florida, Nevada, Arizona and Washington, D.C., where inventories of unsold homes have soared. Builders and sellers also are offering lots of incentives to buyers, including free kitchen upgrades, help with closing costs and even new cars.

Besides being interesting evidence of a possible impending crash in housing prices, it also demonstrates the nature of oligopolistic competion. The new home market is an oligopoly because, in any given geographic area, there is a relatively small number of home builders.

Oligopolies are loathe to compete on price. The acceptable way for oligopolies to compete is via marketing. Thus you see Coke and Pepsi advertisting about how their products fit in with your lifestyle (they haven't even bothered to advertise based on quality since the Pepsi Challenge taste tests of the 1970s), but they will never say you should buy one product because it costs less than the competitor's product.

If a home builder has too much inventory that's not moving, the logical way to get rid of it is to lower the price. But home builders don't want to provoke the other home builders into also lowering prices, resulting losses all around for everybody. So instead, the home builders leave the selling price alone but spend more money on marketing.

I predict that home builders won't be successful holding up prices because a larger chunk of the housing market is individual owners selling their used homes. An individual seller doesn't care about how his selling price affects the market, he just wants to sell. The reason why prices haven't crashed yet is because prices are sticky on the way down. Most people are psychologically unable to deal with losses, so they refuse to acknowledge that their house isn't worth what it was a year ago. Home builders are eager to help the individual owners maintain an unrealistic appraisal of their homes' worth by maintaining high sticker prices on new homes. But home builders seem to be fighting a losing battle.

Comments

[Spungen]

I think it has more to do with the psychology of homebuyers and homeowners. Most people want to buy into the priciest neighborhood possible. They don't want to buy somewhere where prices are dropping, because that can create a change in the demographic composition of the neighborhood.

Also, nearby homeowners get angry when new homes down the street sell for less than they paid for theirs. This makes them more likely to oppose new development. Last recession, I saw this create problems for developers seeking approval to build new developments, or further phases of previously planned developments. Although there's no legal justification for denying an application to prop up surrounding home prices, council members and planning commissioners often looked for any other excuse to turn them down or make it more difficult.

[bbartlog]

New home prices (what homebuilders sell) have dropped faster than sale prices of existing homes, while volume has dropped less for new home sales than for existing home sales. Which suggests that the homebuilders really are competing on price, while individual homeowners do have the 'sticky' price mentality and are more reluctant to lower their prices.
I do think it's interesting that sellers are trying to coopt (perhaps 'corrupt' would be a better word) the buyers' agents. Perhaps you have also heard about the practice of selling a house for the asking price (on paper) but giving the buyer back tens of thousands of dollars as a rebate; this is basically a form of mortgage fraud, as it allows the buyer to represent to the bank that his mortgage is backed by a house worth $X when it is really only worth $X less the rebate. Of course this activity also distorts the housing statistics.

Your Coke vs Pepsi example is interesting. Once again you see collusion where I only see an unusual market. Demand for soda seems to be rather price-inelastic in most settings, marginal costs of unit production are tiny, brand loyalty is high... it's no wonder marketing plays such a role. In this case, the problem is that the market share that can be taken by lowering prices is worth less than the lost revenue that the price cuts cause. Suppose Coke has 50% market share at 0.50 per can but could grab 60% market share by dropping their price to 0.40 - even if their costs were zero, this is a losing scenario for them (I assume for simplicity that the overall size of the market does not change). In reality the soda companies do a good job of differential pricing, so that you can buy bulk soda relatively cheaply in some places (0.99 for two liters at the drugstore or whatever) while paying a lot more in other high-demand contexts (0.75 for 20oz from a vending machine).

[The Engineer]

>>Most people are psychologically unable to deal with losses, so they refuse to acknowledge that their house isn't worth what it was a year ago.

What do you mean "losses". A lot of the stickiness is due to straight up greed, not real losses. People know what the asking prices were at the top, and THAT is what they're unwilling to take less than. But most of these people didn't buy at the top, so they're not real losses.

BTW, my parents are selling my childhood home. Freeport, NY. Baldwin schools. 3 bedroom, 1 bath shack. Asking $460k. This is proof positive that people are being just stupid when it comes to prices.

http://www.mlslirealtor.com/unidetails.cfm?mlnum=1890276&typeprop=1&bn=1&CFID=3045625&CFTOKEN=67062351

[Frank N Stein]

I think HS is on to something. Earlier today I went to the gas station, and while inside I purchased some milk. I gave the person behind the counter a smug look; although I realize I am paying more for that milk than I would at the grocery store down the road, I also realize that this is due to oligarchic collusion between the local Indian gas station attendants, who are most likely related to each other.

[Peter]

Homebuilding is a somewhat unusual field because the barriers to entry are relatively low. It doesn't take a huge amount of skill to be a general contractor - much less than it takes to be a subcontractor - and the capital requirements are modest.

[R. Alex]

Frank,

I'm a little out of it tonight. Are you being sarcastic or serious?

[Frank N Stein]

R.Alex,

I was trying to mimic the thought process of a certain blog author:

1) Observing a non-homogeneous situation (price of milk)
2) Making wild assumptions about that differential, using irrelevant data
3) Adding a slightly racial component

And I'm completely serious.

Just kidding.

[Ned]

I've bought six homes, some new, some existing. In my experience, home builders are extremely reluctant to reduce the advertised selling price but will compete aggressively on other items to move the property, especially in a slow market. It's not too hard to understand why. The selling price becomes a matter of public record when the title is tranferred. When other buyers see that a builder has sold a property at a discount, they will ask for the same consideration. So what the builder does, when faced with a request for a discount off list, is offer lots of other goodies instead of a discount. (You don't like the kitchen? I'll redo it to your specs - no extra charge! How about a nice tile shower instead of that cheapo fibreglass insert? Or maybe a hot tub?) This helps maintain the polite fiction that the builder only sells houses at list, since none of this extra stuff shows up in the title transfer, but, in fact, a substantial discount has, in effect, occured.

[Peter]

In my experience, home builders are extremely reluctant to reduce the advertised selling price but will compete aggressively on other items to move the property, especially in a slow market. It's not too hard to understand why. The selling price becomes a matter of public record when the title is tranferred. When other buyers see that a builder has sold a property at a discount, they will ask for the same consideration.

The flip side of this helps explain why car dealers are willing to sell unpopular models below sticker price. Actual sales prices of cars are not matters of public record and therefore cannot be used by other buyers as negotiating tools.

[R. Alex]

Brilliantly done. The logic followed what I see here on a regular basis so closely that I thought you might be serious, in which case you were nuts.