Bryan Caplan  

Nominal Rigidity of What?

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During recessions, hourly pay for realtors and salesmen falls rapidly.  Even if they're largely paid on commission, their unemployment still spikes.  Doesn't this show that blaming unemployment on nominal wage rigidity is misguided?

I think not.  Labor markets for realtors and salesmen simply suffer from a slight tweak on the usual problem.  In these markets, the key rigidity isn't hourly pay.  It's the commission rate.  To clear the market for realtors, for example, their commission needs to fall from the standard 6% to something far less.  But strangely, it doesn't.  Despite a little discounting, the traditional 6% commission is very stable.

Workers in sales may be horrified by the thought of seeing their volume and their commission fall at the same time.  But depending on elasticities, their hourly pay could actually rise.  In recessions, salespeople waste a lot of extra time of waiting around for customers.  Isn't commission flexibility the obvious solution?
 


COMMENTS (21 to date)
RPLong writes:

If salespeople earn (6%) x [sales price] x [number of sales] and we enter a recession, then (6%) x [reduced sales price] x [reduced number of sales] is already a reduced wage.

I don't see why (4%) x [reduced sales price] x [reduced number of sales] would change things much.

Isn't the real problem that sellers are reluctant to lower their prices? (Or that the credit industry has every incentive to keep asset prices as high as possible for as long as possible?)

Arthur_500 writes:

Sticky wages are the greatest impediment to employment outlook. Certainly as a wage earner I like my wages to stick - until I lose my job.

Many people want to see a return to the jobs programs of the Great Depression. However, due to Government regulations and Union power we can't have similar programs. The wages are carved in stone and they won't float with the market.

In the meantime product prices are cut to the bone. Sellers reduce what they feel they can and wages are the third-rail of business economics.

I know a realtor who decided to go into another line of work when he saw the market begin to slow. That's the free market in action. How long is a salesman going to hang around on a car lot waiting for customers for a 4% commission (in my neighborhood they are limited to an 11% commission and have complained bitterly about that "low" rate). They will figure out a better way to make a living.

Not to pick on salespeople but this goes throughout the rest of the economy. Private employers are loathe to drop wages until they have to drop employees. Then they are loathe to hire new employees until they feel comfortable that they will be long-term.

Foobarista writes:

I'm not sure about this. My wife is in "business brokerage", and the problem is a simple lack of buyers, at any price. Even if prices were zero, many businesses wouldn't sell, even as purely "asset sales", as commercial rents are too high.

Since the commission comes out of the sale proceeds, lowering it hugely by percentage would only lower the overall sale price slightly, and wouldn't help to find buyers. And it would help to drive agents out of the business.

As for commercial landlords, the line where they want to "defend" their rents versus lowering them is quite tricky, but generally they don't want to lower rents unless they absolutely have to, as existing tenants may demand lower rents if new tenants get good deals. So, it often makes sense to leave a space vacant for a good while versus renting it more cheaply, and getting your anchor tenant and other stores in your center to demand lower rents. (To avoid a lower monthly rent, you may do up-front free rent, etc.)

Mr. Econotarian writes:

When sales drop off, you may simply need fewer salespeople.

One generally would prefer to keep the best salespeople and fire the worst, rather than keep all of them and reduce everyone's commission. The good salespeople would leave and find another job if you redued their commission anyway, leaving you with only the worst salespeople. And the worst salespeople would be even less motivated and perform worse with lower commission.

I suspect that marginal labor reduction of the worst performers is something that might be neglected in typical analysis of wage rigidity.

Thomas DeMeo writes:

This all boils down to what you think the underlying problem is. Bryan argues that sticky wages prevent labor markets from clearing. However, if you make wages flexible, risk is being transferred to labor from the firm. This may result in more employment if the risk taking of firms stays static, but will that happen? Such a change might cause firms to take far more risks.

I would argue that it is a good thing that this risk is borne by firms and not labor. Entrepreneurs are irrational risk takers by nature. We need them, but if we create too much of a heads I win, tails you lose economy, they will almost certainly drive everyone off a cliff eventually.

Joe Cushing writes:

There are two many people with their hands on the commission. It gets split at least 4 ways. For the average Agent to reduce commission to 4.5% would be to eliminate all of their pay. More productive agents might be able to cut it to 4 or 3.5% before eliminating all of their pay. It's kind of hard to tell the selling agent/agency that you are going to cut their end because they will discourage people fro buying the home or they will right the commission back into the contact.

The most valuable thing NAR has is their network. In the age of free networking, I can't believe a competing network hasn't opened up in a significant way. There is so much inefficiency in the current system it's nuts. Agents spend most of their time trying to find deals and very little time actually selling houses. We only need about 1% of the real estate agents we currently have. One of the reasons there are so many agents is because anybody can become one as there is no pay commitment from the agency. Anyone reading this could be employed as an agent in one week if they wanted to. Most of you would just not earn any money.

Joe Cushing writes:

I should make better use of the preview section. *too

SheetWise writes:

I think Foobarista has it right -- the illusion of value has to be defended. I find it interesting that in our local market the published commercial rents have not dropped by a penny in the last five years. I can easily find a commercial lease with a two year term that offers a custom build-out and six months of free rent -- but the monthly rate will not budge.

Bob Knaus writes:

You've missed an important element, Bryan - the sales quota.

If you have to manage a sales team through a recession, you want to keep the best and dump the rest. Set the quota right and it's pretty much automatic. Cut the commission, and your best salespeople will leave your team for a competitor.

Fralupo writes:

This looks like a wage-rigidity story, but it has yet to be shown. The rise in unemployed realtors would indicate their commission is too high (only?) if:

1) On a marginal basis the spread between what a seller is willing to accept and a buyer is willing to pay is pro-cyclical. That is, during recessions buyers or sellers become more aggressive then they otherwise would be and the commission is what is keeping the deal from happening. In this scenario the realtor's commission is always keeping some transactions from happening, but the effect is aggravated in recessions and reduced in expansions.

2) Realtor-less transactions don't fall as much during recessions as much as deals with realtors, indicating that the "value-added" or marginal product of a realtor has fallen.

Neither of these things are shown.

It seems to me that unless the number of realtors-per-transaction varies the more likely reason for why their unemployment swings a lot are the swings in the number of houses sold rather than their wage.

Waiters get two and a half times as much in tips than realtors get in commission (15% v. 6% - not counting wages), but we don't blame excessive tipping for waiter-unemployment. Should we?

Costard writes:

+1 Foobarista, Fralupa. It is not real estate agents being sold but real estate. If volume declines, so does the salesforce -- period.

And sticky prices aren't the problem.

Housing satisfies both a consumption and an investment need. Lower prices may be market-clearing on the consumer side, but they also make houses a worse investment. To the extent that the market is dominated by speculators - say, during or immediately after a housing boom - a fall in prices will reduce demand. The only way you clear such a market is by waiting for consumption to establish a floor, or fear to subside. These are functions of time, not price.

Which is precisely the issue. Prices come unglued during a crisis; they tell us nothing about demand. When that happens, a lot of things become inelastic, and there's nothing the Federal Reserve can do about it. Nor should it try.

Hana Noca writes:

Bryan,

Sorry, but you are wrong. In real estate (or business brokerage) transactions the commission is paid by the seller. The commission is netted from the gross earned by the seller. While many sellers use the original purchase price + accumulated expenses + selling expenses formula to set a price, the actual sales price is based on the purchaser's perceived value of the transaction irrespective of the commission (the market we all believe in). The lack of sales is a result of buyers expecting lower prices and sellers resisting lower prices, the commission has no bearing on these situations.

Hana Noca writes:

Bryan,

As an additional comment, based on your statements shouldn't the converse also hold true, that as sales prices rise the commission rate rises? While this may happen occasionally, the observed phenomenon is offers being made above the list price of a property (California booms multiple times during the past 40 years, apologies to all who have not had to endure it and the annoying brilliance associated with it). This raises the income of the agents without changing listing prices or commission rates.

Fralupo writes:

@Hana,

While from an accounting perspective the commission gets paid by the seller, from an economic perspective it is likely that both the seller and the buyer pay for it. Determining exactly how much each party paid requires knowing exaclty how price sensitive they are (what is the marginal elasticities?). Only in the case where the seller has no sensitivity to price (they HAVE to sell the home to this buyer - their supply is perfectly inelastic) does the seller bear the complete burden.

This is just like how taxes affect transactions. Sales taxes are "paid" by the buyer and excise taxes are "paid" by the seller, but economic theory sees both buyer and seller losing out because of each tax.

Megan writes:

The market clearing price in most markets has dropped more than 6%. This is the relevant constraint on real estate sales, and slashing the commission to 0% would not change it by enough to make up the lost income on the few sales you get. Also, real estate agent's commission is only about half of closing costs for an average house in an average area.

Likewise in many other areas; the market clearing price is now lower by much more than the salesman's commission. And since the salesman cannot actually live on nothing, a market clearing price of exactly [oldprice]-[commission] doesn't really help.

Lowering commissions for salespeople will only help much either in markets with absolutely enormous commissions (but those are markets with huge churn and/or other weird features), or ones where the drop has been slight. And ones where the drop has been slight don't see that much of the unemployment, because employers hate to fire, especially when it may cost them a relationship that will be valuable when the economy turns up. Salesmen get fired en masse when the business is in big trouble, at which point, their commission is the least of it.

Mamimum Liberty writes:

This is at least implied by others, but I thought I would say it more clearly (or, at least, in a way that I understand better).

I am only going to use home sales as my example.

The prices that home-buyers see are all-in prices for the home, the transfer taxes, documentation fees, financing charges, all those miscellanenous expenses, and the broker's commission. The prices at which buyers are willing to buy (i.e. for the buyers' demand curve) are for this gross package.

The prices that home-sellers see are net prices for the home, after taxes, fees paid to third parties, and the broker's commission. The prices at which sellers are willing to sell (i.e. for the seller's supply curve) are for this net package.

My thought is that most demand movement has been through a leftware shift of the demand curve. That is, people look at the housing market and just say that they don't want to play right now or they can't get financing. Even flippers leaving the market is a movement of the curve because it is in anticipation of future price decreases. I'm not sure what to think about the shape of the demand curve, and I know it matters, but I'm going to ignore that for now. (My excuse being that government economists often decide that anything they don't know must be irrelevant, so it must be OK.) I'll just pretend it is a 45 degree slope for now, or that the effect of movement of the curve is so big that it swamps any effect of movement along the curve.

On the supply curve, it seems to me that most of the movement is along the curve. That is, the curve is pretty flat because so many sellers would be unwilling to take an equity loss. (At least, it would be flat to the left of pre-crash prices. Presumably it might be a kinked supply curve.) That unwillingness would have been true either before or after the crash. There was probably some movement rightwards of the curve due to changes in ownership due to foreclosure, as unwilling sellers are forced to sell. (At least I think that's the right way to think about it.)

The result is what we see. Home sale prices moving less than we might have guessed, but with a huge decline in volume.

Now introduce the brokers' commission as a wedge between demand and supply. Given the big movement of the demand curve and the flat shape of the supply curve, it seems that one could eliminate the entire commission without changing the outcome much. So, we would see unemployed and underemployed brokers at the macro level anyway.

But then beyond the question of why we see unemployment is why we don't also see falling commissions. One would think that, even if there were too few deals to keep all the current brokers in the market, we would see at least some cut their fees to get the marginal deals to close.

I think that brokers don't advertise lower rates for three reasons. First, it sends a signal of poor quality, especially for where the story is "the other side pays my fees." Second, large sale-side brokers may have deals with institutional sellers where the seller gets most-favored customer treatment on fees. Third, cutting fees will incur the disfavor of peers in a highly networked culture of connections.

Instead, I think that brokers do other things that reduce the wedge between the buyer and seller. The broker may actually quietly reduce their commission when requested to get the deal done. They might even signal this in discussions with the client before-hand, though that might be a false or contingent signal. ("We'll work with you.") They may pay for things that help get the deal done. For example, where some small repair is needed, they may come out of pocket for it.

So, I suspect that, at a micro level, we're only seeing the headline commission, not the real commission.

Beyond that, I think there is also an effect from part-time relatively new entrants to the brokerage market exiting it quickly. That is, if you got your brokers' license in 2008, you probably paid whatever nominal renewal fees there were, but you probably got another job by now or never left your day job to begin with. (No, not 100%. But maybe a majority.) That creates the appearance of unemployed brokers, but they are not exertimg much downwards pressure on prices because they are not actively marketing their services. In fact, they would maintain their existing prices, hoping to get a commission by random luck or when one of their friends sells. (I recall, from undergrad, a model of high unemployment in developing-country cities where rural labor moves to the city knowing that they have a low percent chance of getting much higher pay, and sticking it out for long periods. It would be like that.)

Max

P.S. This started out as a three-line observation. Sorry for the length.

Hana writes:

@Fralupo,

Sales agents are nothing like taxes. Furthermore I disagree that they are considered the same as taxes in economic theory. I don't recall that equation from grad school, it's been a long while, so correct me if I am wrong. As an example let's consider a door to door Fuller Brush salesman. Until he knocks on the door, makes a pitch and closes a sale, there is no economic activity. How in that case is it the same as a tax? Salesman yields transaction yields economic activity, versus a tax in thin air yields what? It would seem that the salesman provides a value to the transaction that does not exist in his absence. Why is real estate different? If it is different, is marketing also considered the same as a tax in economic theory? Additionally why should the labor called "salespeople" be different than all the other labor components that go in to the cost of a product? When I buy a loaf of bread, is the baker just a 'tax' in the transaction?


In spite of Bryan's comment, "In recessions, salespeople waste a lot of extra time of waiting around for customers" (which by the way is a completely insulting and derogatory comment to anyone who is a sales professional), they perform a significant function in the transaction. They are in the marketplace constantly, buyers or sellers most typically are infrequently in the market. In order to be paid, they are actively trying to connect buyers with sellers, they seek out both buyers and sellers to make the transaction happen. They are information sources regarding communities, including schools, churches, government activities, traffic patterns, pending construction, etc.

A few comments other comments on Byran's other statements: First, from my experience in almost a dozen states, the brokers not agents (salespeople) set the commission rate. Second,in my 30+ years of management experience, when sales are the toughest is when sales people earn their pay. During difficult periods I would suggest paying higher not lower commissions. You want people that are motivated to make sales, they earn their keep by finding customers and closing sales, not by sitting around and waiting. Let's face it, as a firm you want sales, not non-sales. The distinction may be lost on Bryan, but, clerks sit around, sales people make things happen.

Hana writes:

@Fralupo,

I would beg to differ with you. The economic transaction should not in a two party situation include the commissions. However, reality is that many times at the closing table the buyer and seller determine that some more money needs to come out of the price, they encourage (pressure) the broker to reduce his fee to cover that difference (the only difference between what I want and what you are willing to pay is his commission). In that case it is not identical to a tax but instead is a three part negotiation including an agent. The agent facilitates the sale and his fee for his expertise may be negotiable.

As far as the burden of a sale, the salesperson is a component in the price of the product. Is the expense of a 'salesperson' any different than any of the other labor components of a product? An illustration might be helpful. A Fuller Brush salesman knocks on the door, presents his product and closes a sale. Without the salesman there is no sale. By equating the salesperson as equal to a tax from an 'economic perspective', there is no value to the transaction added by the salesperson. Salesperson yields transaction yields economic activity vs. sales tax yields what? As an additional example, is the cost of an auctioneer identical to a tax? If no transaction takes place (i.e., no economic actors), there is no economic activity. The seller receives no money, the buyer receives no goods. In the presence of an auctioneer, buyer and seller meet, and goods are transferred. There is a fee for this but all parties interests are met. Did I miss the classes where this is identical to a tax?

What you, and maybe Bryan, are not describing is the value added to the transaction by the salesperson. (Bryan's perspective of 'In a recession, salespeople waste a lot of extra time of waiting around for customers' is demeaning, and wrong. Professional salespeople are actively seeking buyers and sellers no matter what the economic conditions. In the very slightest, actually even slighter than that, concession to Bryan, there actually had to be a last buggy whip salesman. While we all may have seen Glengarry Glen Ross and Death of a Salesman, these plays are not authentic to the sales role or experience).

Some further comments on Bryan's statements. First, real estate commissioned sales people are a poor choice to prove your point. The commissions for real estate are set by the brokers, not the sales people. Even if a sales person was willing to accept a lower commission, the total commission paid would not change. Second, the market size may be limited. In any location only a limited number of people move in and out of the market. While sales people may have the ability to convert some owners to sellers and some renters to buyers, the fact remains that all communities have a physical limit to the number of transactions that may take place. Third, the notion that during difficult times commission rates should fall. Why does this satisfy any market clearing notion? As a seller during difficult times, wouldn't someone want the best possible salesman? Wouldn't that indicate that since real estates prices are falling, as a motivated seller you would be best served by paying a higher commission? That being noted, another explanation for the observed phenomenon could be that the barriers to entry in to the real estate field are relatively low, and that in a downturn agents are still listed as active when in fact they are only nominally active.

Finally, is the 6% commission rate the factor holding back sales? Since the commission only takes place after a sale, in the absence of commissions how many more sales would occur? Since salesperson income is directly related to sales revenue, what is the evidence that commissions are the factor reducing sales? By extension what is the optimal commission rate during any time during a business cycle? Coming back to the real world, when times are good, any salesperson is fine, when times are bad, pay more for quality.

Jim Rose writes:

Alchian (1969) lists three ways to adjust to unanticipated demand fluctuations:
• output adjustments;
• wage and price adjustments; and
• Inventories and queues (including reservations).

Alchian (1969) suggests that there is no reason for wage and price changes to be used regardless of the relative cost of these other options:
• The cost of output adjustment stems from the fact that marginal costs rise with output;
• The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer; and
• The third method of adjustment has holding and queuing costs.

There is a tendency for unpredicted price and wage changes to induce costly additional search.

Long-term contracts including implicit contracts arise to share risks and curb opportunism over sunken investments in relationship-specific capital.

These factors lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability.

Alchian and Woodward’s 1987 'Reflections on a theory of the firm' says:

“… the notion of a quickly equilibrating market price is baffling save in a very few markets.

Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances?

If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears?

… But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”

Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

Alchian and Woodward explain unemployment as a side-effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets. They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm make with one another.

Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue. Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and are forms of exclusive dealership or take-or-pay contracts.

Fralupo writes:

I was reacting to this :

The lack of sales is a result of buyers expecting lower prices and sellers resisting lower prices, the commission has no bearing on these situations.

Which seemed to be saying that the only reason a sale doesn't happen is because sellers don't accept low prices. One might equally say that the only reason sales don't happen is because sellers expect higher prices and buyers resist higher prices. Intuitively any transaction has a buyer and a seller, and it cannot be the case the seller is always wrong about what the price should be. Buyers probably undervalue how much a home is worth about as often as sellers overvalue it.

What I meant with the excise tax example is that the way the commission affects the transaction is similar to how sales and excise taxes affect their transactions. Perhaps excise taxes are a bad example because often they are fixed instead of a percentage. Maybe a VAT or an import tariff would be a better example of a percentage tax paid by the seller that is borne also by the buyer.

Certainly the salesman adds value, but is the value-added ad valorem to the price? You raise two examples, bakers and traveling salesmen. They are interesting. Bakers don't usually get paid X% of the sales price, while salesmen most of the time do. I'm not sure I would think of the buyer's agent in a real estate transaction as a salesman for the seller though.

The problem that I see is that seller is well aware that he doesn't get to keep the commission. The fact that they don't get the whole sales price cannot be hidden from them, and will affect what kind of price they'll accept - probably by raising it.

You recognize this when you bring up situations where the commission is discounted and the savings passed on the buyer. Is the seller indifferent between the sales price going down by X% and the commission going down by X%? Why did the commission need to go down to make the transaction happen, and does this only happen when buyer and seller recognize that the agents haven't added as much value to the transaction as they normally would? If the real estate agent said "No, I'm not willing to accept a lower commission", and the transaction doesn't happen, whose "fault" is it then?

I agree with you, however, that most of the time an extra 6% or whatever wouldn't "make" as sale happen - if real estate agent employment swings a lot it is probably because home sales swing a lot, and they probably can't lower their rate enough to get back to full employment. On the margin it might matter, but probably not at the magnitude needed to make sure no one loses their job.

Hana writes:

@Fralupo

Thank you for your comments.

I really believe Bryan's case doesn't prove his intended point. He is approaching the problem from the labor cost side of the equation. The underlying issue is that job seeker mobility slows down during a recession, resulting in a lower volume of real estate transactions.

The stickiness of real estate salaries is a function of the nature of sales people and employers. For a core group of real estate sales people, recessions are a time to regroup, refocus energies, and build contacts throughout the community. They are truly successful agents and will reap the future rewards for their pre-expansion efforts.

A second group are agents that only join the sales field as the momentum is growing. They ride the wave up during the boom times, and never really quit as the market falters. For them real estate may or may not be a primary occupation, but when considering participation, and therefore average salaries, they are included in the mix. Since they are only paid at the closing, they have little interest in declaring themselves no longer employed in real estate. Instead they maintain an identity as an active agent. Since many employers prefer to hire employed as opposed to unemployed workers, this would be a rational strategy on their part.

A final point about salesman. They never see the manure, they only search for the pony. Their willingness and drive to accept erratic salaries, with the hope of a big payday, is en-grained in their psychological makeup. They are overwhelmingly optimistic. I would suggest this is the key reason the market does not clear. You do not get involved sales if you do not believe that you can personally make a difference that will positively impact your income.

With regard to the market clearing ability of lowering the commission rates, if you were to lower the commission rates enough, there would be no sales people unemployed, because there would be no sales people. The way to increase the salaries is to increase sales. On margin the commission earned by the salesperson does not stop a transaction from happening.

BTW: Listing broker 1.5%, Listing agent 1.5%, Selling broker 1.5%, Selling agent 1.5%.

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