Prospect Theory in the Housing Market

Change log
Meng, Chunming 

Loss aversion, a behavioural bias on people’s asymmetric attitudes towards losses and gains, is a core concept in prospect theory. Similar to behavioural sciences in general, loss aversion has been widely applied in various research areas. However, evidence of this concept in residential real estate remains scarce and limited. Advances in this line of research will considerably enhance our understanding of much-debated topics in housing research. This thesis aims to provide a comprehensive understanding of the loss aversion effect in the housing market. On the basis of a review of loss aversion literature, this thesis explores the three following topics in three studies. The first study in the first-hand housing market examines developers’ aversion to land costs and its effect on their pricing strategy of final products, that is, housing units. I choose Beijing, the capital city of China, as the study area because it has good quality land transaction data and it has experienced a dramatic boom in land and house markets in the past decade. Empirical analysis reveals that developers exhibit significant levels of aversion towards losses in the land acquisition process, and loss-prone developers set higher prices for houses than they otherwise would set without such losses to achieve breakeven point. The second study exploits households’ reference dependence behaviour in the second-hand housing market. It aims to locate a precise reference point which is a key factor to reliable loss aversion investigations. The main prediction is that reference points are formed under the influence of left-digit bias although sellers use the price they paid previously to purchase the property as a reference for later home-selling decisions. Round-number prices are precisely perceived, whereas prices just below round numbers, that is, charm prices, are perceived much lower than their actual values. Resultant systematic differences in reference points cause resale prices to differ. The resale prices for previously charm-priced properties are 4% lower than for previously round-priced properties after controlling for the observables and a large set of fixed effects based on the repeat sales data in the Greater London region, UK. II The third study aims to quantify the inattention and loss aversion level. The third study, based on the widely-accepted inattention framework, provides an estimate of inattention levels (0.118) used for reference point formation in the housing sector. The study estimates the loss aversion level to be 4.278 under the new reference point. The loss aversion level is higher and the inattention level lower in home-buying and home-selling decisions compared to the estimates in other economic settings.

Bao, Helen
Housing, Behavioural economics, Prospect theory, Inattention
Awarding Institution
University of Cambridge