Friday, October 19, 2007
The Triumph Of Unreason
Examining why you are not always rational when purchasing real estate
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Neoclassical Economics is built on the assumption that humans are rational beings who have a clear idea of their best interests and, moreover, strive to extract maximum benefit -or "utility" as economists are fond of saying – from any situation. Seeing from this viewpoint, price helps people decide which combination of work, spending and saving suits them best. In real estate, however, things are not quite this simple.
Theory of price asserts that the market price reflects interaction between two opposing considerations. On the one side are demand considerations, while on the other side there are supply considerations. In real estate, however, there is another factor – value - which is frequently confused with price, because market value is calculated as the quantity of some good multiplied by its nominal price. Clearly this should not be so, in that value represents by definition how much a product or service is worth to someone relative to other things. But then, of course, the worth of something is in function of consumer's perception. Thus the old saying that real estate is only a matter of emotion.
Neoclassical Economics assumes that the process of decision-making is rational in that, as mentioned at the beginning of this article, humans are viewed as rational beings intent at maximizing utility. But this too is only partly true when it comes to real estate. And there is now growing evidence that decision-making draws heavily on emotion, even when reason is clearly involved. In other words, scientific evidence is being presented that humans are not only irrational in real estate – they are irrational, period. This is the triumpf of unreason.
The role of emotions in making decisions makes perfect sense. It is wired in our brain, as our ancestors had to weigh frequently the pros and cons of, say, obtaining food, whom to mate with and confronting or fleeing threats. The neural mechanism evolved in such a manner so as to maximize utility at minimum cost of energy. Since emotions is the mechanism by and through which animals are prodded towards such maximization, evolutionary and economic theory predicts the same application in humans. But the question today is: does this mechanism work when we have to respond to the stimuli of urban modenity?
It appears that it does not.
Researchers have discovered that different parts of the brain are involved at different stages in the decision-making process. The "nucleus accumbens" for instance, the collection of neurons within the forebrain, is the most active part and its level of activity correlates with the desirability of a certain product. It processes rewarding stimuli such as food, recreational drugs and monetary gains, as well as the anticipation of those rewards.
Price, however, increases activity in different parts of the brain. Excessively high prices increase activity in the "insular cortex", a region of the brain linked with expectations of pain, monetary loss and the viewing of upsetting pictures. This is also the part of the brain that lights up when consumers decide not to purchase an item. Price information activates also the "prefrontal cortex", that is the anterior part of the frontal lobes. This region is involved in rational calculations as well as in the balancing of the expected and actual outcomes of monetary decisions. Particularly, the reaction of the prefrontal cortex seem to correlate with both desirabilty of a product and its price, rather than to price alone. This evokes in turn a higher sense of a good bargain, and it precedes the decision to buy.
All the foregoing seems to contraddict orthodox economic theory. Rather than weighing the present good against future alternatives, people seem to balance the immediate pleasure of the prospective possession of a product vis-à-vis the immediate pain of paying for it. Which makes perfect sense in a cash purchase, as the future utility of what is being given up is embedded in the price that is being paid for it. But when it comes to real estate, where payments are practically always deferred by way of mortgaging, the balance between the pros and cons of purchasing appears to be modulated in favor of the pros. This is so because of the abstract nature of mortgage deferred payments.
Research continues, of course, and nothing is definitive as of yet. But if in fact it turns out to be proven that buying on mortgages, just like buying on credit, eases the pain of purchasing, then real estate purchase financing will have to join the list of things such as fatty and sugary foods that subvert human instincts in ways that seem pleasurable in the present tense, but which in fact can have a long and malign aftertaste.
Luigi Frascati
Theory of price asserts that the market price reflects interaction between two opposing considerations. On the one side are demand considerations, while on the other side there are supply considerations. In real estate, however, there is another factor – value - which is frequently confused with price, because market value is calculated as the quantity of some good multiplied by its nominal price. Clearly this should not be so, in that value represents by definition how much a product or service is worth to someone relative to other things. But then, of course, the worth of something is in function of consumer's perception. Thus the old saying that real estate is only a matter of emotion.
Neoclassical Economics assumes that the process of decision-making is rational in that, as mentioned at the beginning of this article, humans are viewed as rational beings intent at maximizing utility. But this too is only partly true when it comes to real estate. And there is now growing evidence that decision-making draws heavily on emotion, even when reason is clearly involved. In other words, scientific evidence is being presented that humans are not only irrational in real estate – they are irrational, period. This is the triumpf of unreason.
The role of emotions in making decisions makes perfect sense. It is wired in our brain, as our ancestors had to weigh frequently the pros and cons of, say, obtaining food, whom to mate with and confronting or fleeing threats. The neural mechanism evolved in such a manner so as to maximize utility at minimum cost of energy. Since emotions is the mechanism by and through which animals are prodded towards such maximization, evolutionary and economic theory predicts the same application in humans. But the question today is: does this mechanism work when we have to respond to the stimuli of urban modenity?
It appears that it does not.
Researchers have discovered that different parts of the brain are involved at different stages in the decision-making process. The "nucleus accumbens" for instance, the collection of neurons within the forebrain, is the most active part and its level of activity correlates with the desirability of a certain product. It processes rewarding stimuli such as food, recreational drugs and monetary gains, as well as the anticipation of those rewards.
Price, however, increases activity in different parts of the brain. Excessively high prices increase activity in the "insular cortex", a region of the brain linked with expectations of pain, monetary loss and the viewing of upsetting pictures. This is also the part of the brain that lights up when consumers decide not to purchase an item. Price information activates also the "prefrontal cortex", that is the anterior part of the frontal lobes. This region is involved in rational calculations as well as in the balancing of the expected and actual outcomes of monetary decisions. Particularly, the reaction of the prefrontal cortex seem to correlate with both desirabilty of a product and its price, rather than to price alone. This evokes in turn a higher sense of a good bargain, and it precedes the decision to buy.
All the foregoing seems to contraddict orthodox economic theory. Rather than weighing the present good against future alternatives, people seem to balance the immediate pleasure of the prospective possession of a product vis-à-vis the immediate pain of paying for it. Which makes perfect sense in a cash purchase, as the future utility of what is being given up is embedded in the price that is being paid for it. But when it comes to real estate, where payments are practically always deferred by way of mortgaging, the balance between the pros and cons of purchasing appears to be modulated in favor of the pros. This is so because of the abstract nature of mortgage deferred payments.
Research continues, of course, and nothing is definitive as of yet. But if in fact it turns out to be proven that buying on mortgages, just like buying on credit, eases the pain of purchasing, then real estate purchase financing will have to join the list of things such as fatty and sugary foods that subvert human instincts in ways that seem pleasurable in the present tense, but which in fact can have a long and malign aftertaste.
Luigi Frascati
Real Estate Chronicle
Labels: REAL ESTATE ECONOMICS
