Information Frictions and Housing Market Dynamics

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Information Frictions and Housing Market Dynamics Elliot Anenberg 2012-48 NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

Information Frictions and Housing Market Dynamics∗ Elliot Anenberg† July 18, 2012 Abstract Thispaperexaminestheeffectsofselleruncertaintyovertheirhome value on the housing market. Using evidence from a new dataset on home listings and transactions, I first show that sellers do not have full information about current period demand conditions for their homes. I incorporate this type of uncertainty into a dynamic search model of the home selling problem with Bayesian learning. Simulations of the estimated model show that information frictions help explain shortrun persistence in price appreciation rates and a positive (negative) correlation between price changes and sales volume (time on market). ∗This is a revised version of my job market paper. I am very grateful to my advisor, Pat Bayer, and committee members Jimmy Roberts, Andrew Sweeting, and Chris Timmins for comments. I also thank Peter Arcidiacono, Ed Kung, Jon James, Robert McMillan, Karen Pence, and Jessica Stahl. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. †Federal Reserve Board of Governors, Washington DC. Email: elliot.anenberg@frb.gov 1

1 Introduction Since the seminal work of Stigler [1961], economists have long recognized the importance of imperfect information in explaining the workings of a variety of markets. Surprisingly, given its importance to the macro economy, little work has focused on the effects of imperfect information in the housing market.1 The housing market is a classic example of a market affected by imperfect information. Each house is a unique, differentiated asset; trading volume of comparable homes tends to be thin due to high transaction costs; and market conditions are highly volatile over time. These features of the housing market make it difficult for sellers to determine their home values at any point in time. InthispaperImodeltheeffectofthistypeofselleruncertaintyonthehousing market. The model adds a framework for seller uncertainty and Bayesian learning in the spirit of Lazear [1986] to the typical features of the dynamic micro search models in the housing literature (Carrillo [2010], Horowitz [1992], Salant [1991]). I estimate the model and use it to test whether uncertainty is important for explaining several key stylized facts about housing market dynamics that have attracted much attention in the literature, in part because they are inconsistent with the predictions of standard asset pricing models. The first fact is that price appreciation rates display predictability in the short-run. In their seminal papers, Case and Shiller [1989] and Cutler et al. [1991] find that a 1 percent increase in real annual house prices is associated with a .2 percent increase the next year, adjusting for changes in the nominal interest rate. Numerous other studies have also documented this persistence, and it has led some to question the efficiency of the housing market because it cannot be explained by fundamentals.2 Thus, an important question is whether the amount of short-run momentum found in the data is consistent 1Levitt and Syverson [2008] and Taylor [1999] are examples of studies that focus on the effectofinformationasymmetriesonmicrofeaturesofthedata,butlessisunderstoodabout the broader effects of information frictions on housing market dynamics. 2For example, Case and Shiller [1989] and Glaeser and Gyourko [2006] find that persistence in rents and wages cannot explain the amount of serial correlation in prices, and thus cite inefficiency as a likely explanation. See Cho [1996] for a survey of the literature on house price dynamics. 2

with a rational model of the housing market. Another key feature of housing markets is that sales volume and marketing time are positively and negatively correlated with sales price changes, respectively. The existing literature has convincingly emphasized the importance of search frictions and credit constraints as explanations.3 Here, I investigate whether imperfect information is an additional friction that causes housing markets to display these unusual time series properties. At a more micro level, the literature has also documented a set of stylized facts about the behavior of individual sellers (Merlo and Ortalo-Magne [2004]). For example, sellers tend to adjust their list prices downwards, even when market conditions do not change, and sales prices for observationally equivalent homes depend on time on market (TOM). These empirical patterns are inconsistent with the predictions of existing search, matching and bargaining theories of housing transactions, which do not accommodate duration dependence in seller behavior.4 In addition to explaining the macro stylized facts discussed above, I will show that uncertainty and the gradual acquisition of information during the listing period is an explanation for these and many other dynamic features of the micro data. I motivate the model with reduced form evidence that lack of information does affect selling behavior. While several studies show that homeowners misestimate their home values at various points during their ownership tenure5, I am not aware of other studies that investigate the information set of sellers when the home is on the market for sale. Since most sellers hire a realtor when they are ready to sell their homes, this is potentially an important distinction. The reduced form evidence comes from a new micro dataset that I compile from two independent sources. For a large sample of single family homes listed for sale with a realtor in the two major California metropolitan areas from 2007-2009, the combined dataset describes the precise location of each listing, list prices each week that the home is listed for sale, TOM, and 3SeeStein[1995],Ortalo-MagneandRady[2006],GenesoveandMayer[1997],Anenberg [2011a], Krainer [2001], Ngai and Tenreyro [2010]. 4See Carrillo [2010], Horowitz [1992], Novy-Marx [2009], Chen and Rosenthal [1996]. 5See for example, Goodman and Ittner [1992], Kiel and Zabel [1999]. 3

sales prices. I exploit cross-sectional variation in the heterogeneity of the housing bust across neighborhoods to test whether sellers price their homes using the most up to date information about local market conditions. I find that they do not; initial list prices are overly sensitive to lagged market information. The regression results show that for two comparable homes in a given time period, the home in the neighborhood that experienced the greater amount of price depreciation in the previous four months will be listed at a higher price on average. Neighborhood price levels from longer than four months ago do not provide any additional explanatory power for initial list prices. This finding is consistent with anecdotal evidence that sellers, with the help of realtors, look to previous sales of similar houses when pricing their homes, presumably because comparable sales volume can be thin and sales prices become publicly available with a lag. Evidently, realtors do not fully adjust for the downward trend in prices during my sample period. Using list prices to infer seller beliefs is complicated by the fact that many unobservables affect list prices, and some of them may be correlated with lagged market information. However, the correlation between sales prices and lagged neighborhood price depreciation confirms that expectation bias is indeed the explanation for the inflated list prices. In particular, I find that for the same homes that have higher list prices because of high lagged neighborhood price depreciation, sales prices are lower. Theoretically, higher list and lower sales prices can arise when sellers overstate their home value, but this crossing pattern, which is shown in Figure 1, cannot easily be explained by many alternative explanations for the high list prices including loss aversion (Genesove and Mayer [2001], Anenberg [2011a]), equity constraints (Stein [1995],Genesove and Mayer [1997], Anenberg [2011a]), high unobserved home quality, or low unobserved motivation to sell, among others. In other words, unobservables that increase list prices should also increase sales prices.6 This 6InFigure1,thetwostylizedneighborhoodstrendatthesamerateafterthelistingdate. In the empirical specification, I control for heterogeneous trends across neighborhoods by normalizing list and sales prices by a time varying, neighborhood specific sales price index. 4

simple identification strategy for expectation bias could be useful in other settings where list prices or reserve prices are observed in addition to selling prices. Having established this new evidence that information frictions are an important part of the home selling process, I incorporate them into a single-agent dynamic micro model of the home selling problem. I model seller uncertainty as a prior on the mean of the distribution of buyer valuations for their home, and this prior may be biased depending on the information available. Sellers set list prices to balance a trade-off: a high list price strengthens their bargaining position if a buyer arrives, while a low list price attracts more offers and increases the pace of learning. Conditional on the list price, buyers with idiosyncratic valuations arrive randomly. The house sells if the buyer’s valuation is above the seller’s reservation price, which depends on the value of declining the offer and continuing the dynamic process. Sellers in the model behave rationally and optimally given the available information. I estimate the parameters of the model using simulated method of moments.7 Theparameterestimatesthemselvesareinformativeabouttheamount of information that sellers have and the pace of learning. I find that the standard deviation of the typical seller’s prior about their home value is $38,000, which is about 7 percent of the average sales price. Learning over the course of the marketing period decreases this standard deviation by 37 percent by the time of sale, on average. Simulations of the estimated model show that annual aggregate sales price appreciation rates persist even when changes in the market fundamentals do not. The model can account for over half of the persistence typically found in the data. To see the intuition behind this result, suppose that there is uncertainty about demand at time t, the expected value of demand is γ at time t, and the realization of a permanent demand shock is higher than expected at γ + (cid:15). Even if every seller receives an idiosyncratic signal at time t that 7In this respect, my paper contributes a new application to the growing literature on empirical learning models. See, for example, Crawford and Shum [2005], Ackerberg [2003], Hitsch[2006],ErdemandKeane[1996],Narayananetal.[2007]. Ihighlightacoupleunique features of my learning model in Section 4.1. 5

demand is high, in the absence of a mechanism (either formal or informal as in Grossman and Stiglitz [1976]) that publicizes private information, the reservation price of the average Bayesian updating seller will not fully adjust to the shock at time t. In subsequent periods, after more information about the positive shock becomes available, reservation prices, and thus sales prices, will fully adjust. It is this lag in the flow of information that gives rise to serial correlation in price changes. The same lag in the updating of reservation prices to demand shocks generates a positive (negative) correlation between price changes and sales volume (TOM).Forexample,whenthereisapositivedemandshock,reservationprices are too low relative to the fundamentals, which leads to higher sales volume and quicker sales. The model predicts that a 1 percent increase in quarterly prices leads to a 4.8 percent increase in volume and a 7.2 percent decrease in TOM. These predicted co-movements are comparable to what is observed in the data. Thus, uncertainty does appear to be important in explaining variation in transaction rates over the housing cycle as well.8 A related paper by Head et al. [2011], written recently and independently of this one, also explores the serial correlation of house price changes. Under some calibrations and functional form assumptions, their macro model, which is one of complete information, is also able to generate some, but not all, of the momentum observed in the data. Their model, like mine, does not rely on inefficiency or irrationality of the market. Matching frictions in the spirit of Mortensen and Pissarides [1994] and Pissarides [2000] interact with a lagged housing supply response to cause market tightness (i.e. the ratio of buyers to sellers), and thus prices, to gradually rise in response to an income shock. Futureeffortstoexplainevenmoreofthemomentuminhousingmarket conditionscouldtryincorporatinginformationfrictionsintothistypeofsearch and matching framework. This paper proceeds as follow. Section 2 introduces the data. Section 3 8Theideathatuncertaintyaboutmarketconditionscanleadtoslowadjustmentofprices andsalesisalsodiscussedinBerkovecandGoodman[1996]. However,theideaisintroduced with a more stylized version of the model in this paper, and their model is not taken to the micro data. 6

motivates the model with reduced form evidence that information frictions are an important part of the home selling problem. To investigate the broader implications of seller bias and uncertainty for housing market dynamics, Section 4 develops a model where the flow of information has an endogenous effect on selling behavior. Section 5 and 6 discuss estimation details. Section 7 simulates the model to highlight the importance of information frictions in explaining the stylized facts discussed above. Section 8 discusses the robustness of the results to certain stylized features of the model and section 9 concludes the paper. 2 Data I use home sale and listing data for the core counties of the San Francisco Bay Area and Los Angeles. These counties include Alameda, Contra Costa, Marin, San Francisco, San Mateo, and Santa Clara in San Francisco; and Los Angeles, Orange, Riverside, San Bernardino, and Ventura counties in the Los Angeles area. The listing data come from Altos Research, which provides information on single-family homes listed for sale on the Multiple Listing Service (MLS) from January 2007 - June 2009. Altos Research does not collect MLS data prior to 2006. Since a seller must use a licensed real estate agent to gain access to the MLS, my sample only contains selling outcomes for sellers who use realtors.9 Every Friday, Altos Research records the address, mls id, list price, and some characteristics of the house (e.g. square feet, lot size, etc.) for all houses listed for sale. From this information, it is easy to infer the date of initial listing and the date of delisting for each property. A property is delisted when there is a sale agreement or when the seller withdraws the home from the market. Properties are also sometimes delisted and then relisted in order to strategically reset the TOM field in the MLS. I consider a listing as new only if there was at least a 180 day window since the address last appeared in 9According to the National Association of Realtors, over 90 percent of non-arms length home sales were listed on the MLS in 2007. 7

the listing data. The MLS data alone does not provide information on which listings result inasale, andwhatthesalespriceisifasaleoccurs. Toobtainthisinformation, I supplement the MLS data with a transactions dataset from Dataquick that contains information about the universe of housing transactions from 1988- 2009. In this dataset, the variables that are central to this analysis are the address of the property, the date of the transaction, and the sales price. Using the address, I attempt to merge each listing to a transaction record that is within 1 year of the date of delisting from the MLS.10 I also attempt to merge each listing to a previous sale in the transaction dataset. The latter merge acquires information on the purchase price of each home, which I use to construct a predicted log selling price for each house: pˆ : log predicted sales price for house i located in neighborhood j in month t. ijt I calculate these prices by applying a zip code price change index to the previous log sales price. The price index is calculated using a repeat sales analysis following Shiller [1991]. I let the price index vary by zip code and month. The predicted price measures what the economist expects house i to sell for in time t, and it controls for time-invariant unobserved home quality and differences in neighborhood price appreciation rates. Appendix A.2 describes how I calculate these prices from the data in more detail. AppendixA.1describesmoredetailsofthedatabuildingprocess, including minor restrictions to the estimation sample (e.g. exclude listings where the ratio of the minimum list price to the maximum list price is less than the first percentile). I exclude listings where the initial listing date equals the first week of the sample and listings where the final listing data equals the last week of the sample to avoid censoring issues. I also drop all listings that do not merge to a previous transaction.11 10Thesalesdateinthetransactiondataistheclosingdate,whichlagstheagreementdate by a month on average. 11I compare summary statistics of the limited sample to the full sample to ensure that my sample is representative. The failure to merge here is because there is an idiosyncracy 8

2.1 Summary Statistics Figure 2 shows the Case-Shiller home price index for Los Angeles and San Francisco from 2007 - 2009. During the years where the MLS and transactions dataoverlap, bothcitiesexperiencedcomparableandsignificantpricedeclines. In Los Angeles, the market peaked in September 2006, and fell 37.5 percent in nominal terms through December 2009. The San Francisco market peaked in May 2006, and also fell by 37.5 percent by the end of 2009. The prolonged episode of falling prices, low sales volume, and long marketing time that my sample period covers is not an isolated event; Burnside et al. [2011] show that sustained booms and busts occur throughout housing markets around the world. For example, in real terms, Los Angeles experienced a comparable price decline during the housing bust of the early 90’s.12 Thus, my sample and my results like characterize market dynamics during cold housing markets more generally. Table 1 presents summary statistics for the listings that sell. The median time to sale is about 3 months, and there is a lot of variation. Twenty five percent of listings sell in less than 5 weeks and 25 percent take more than 25 weeks to sell. Most sellers adjust their list price at least once before they sell. These list price changes tend to be decreases: only 6 percent of list price changes are increases.13 Table 2 shows that list price changes occur throughout the selling horizon, and many occur in the first few weeks after listing. These stylized facts about list price changes seem challenging for models with complete information to explain.14 Since some sellers will quickly adjust their inthewaytheaddressesarerecorded, thehouseisnew, orthecurrentownerpurchasedthe house prior to 1988. 12I also find evidence that the percent of transactions that are foreclosures during the recent downturn is comparable to the downturn during the 1990’s. Campbell et al. [2011] alsoreportthattheforeclosurerateisnotunusuallyhighduringtherecentrecessionrelative to the downturn during the 1990’s in Massachusetts. 1350 percent of listings do not sell during the sample period. These withdrawals tend to have longer marketing times and higher list prices (normalized by predicted price) relative to listings that sell. I discuss reasons for these withdrawals in more detail in Section 8. 14For example, list prices could decline in a complete information framework if holding costs increase over time. But to generate list price increases during a market decline and to generate list price changes so quickly after listing likely requires a very flexible parameteri- 9

beliefs in response to new information, the learning model that I present below will also predict changing list prices in the first few weeks and some list price changes that are increases. Few studies have had access to such a large dataset on home listings that includes the full history of list prices for each listing.15 This feature of the data will be important for identifying the parameters of the non-stationary model of selling behavior presented below. 3 Motivating Empirical Facts I begin by presenting strong evidence, which does not rely on my modeling assumptions below, that imperfect information does affect the home selling process. This is important because even though many features of the data are consistent with a model with uncertainty and learning as I show below and as documented in Knight [1996], alternative models may be able to explain these features as well. 3.1 Expectation Bias and List Prices I test whether the initial list price choices of sellers reflect the most up to date market information, or whether they place undue weight on lagged information. Outdated information may affect list prices because the thinness of the marketandthelaginwhichsalesdatabecomepublicmakeitdifficulttoassess current market conditions.16 Conversations with a realtor suggest that lagged zation of holding costs. 15A related study that uses a similar dataset from the Netherlands is de Wit and van der Klaauw [2010]. The authors find empirical evidence that list price changes affect selling outcomes such as the hazard rate of sale. Since list prices have no legal role, they interpret this as evidence that information frictions do exist in the housing market. My study is different from theirs in that they do not actually model the information frictions or address the implications of these frictions on market dynamics. 16Sales data become available only upon closing, which typically lags the date when the buyer and seller agree on price by months. In addition, home price indexes (e.g. Case- Shiller) that process sales data using econometric techniques lag the market by months. 10

comparable sales are often used as a proxy for the current market value.17 I implement this test by regressing the log list price in the initial week of listing, normalized by the log predicted sales price, on lagged price changes according to: pL −pˆ = α +γ +β (pˆ −pˆ )+β X +(cid:15) (1) i,j,t0 i,j,t0 j t 1 i,j,t0−1 i,j,t0 2 i,j,t i,j,t where the 0 subscript denotes that it is i(cid:48)s first month on the market and j denotes the neighborhood. Variation in the dependent variable across listings could be due to several factors, including heterogeneous motivation to sell, time-varying house characteristics, and heterogeneous beliefs about house values. The regressor of interest is the percentage change in average neighborhood prices from the previous month relative to the current month. The average value of pˆ − pˆ is 1.7 percent and the standard deviation is i,j,t0−1 i,j,t0 2.9 percent. I also include month fixed effects, zip code fixed effects, other controls X, and so β is identified from heterogeneity in the variation in price 1 declines across neighborhoods. Column 1 of Table 3 reports the results. Standard errors are clustered at the zip code level. A 1 percent increase in the price depreciation rate leads to a 0.57 percent increase in the list price, all else equal. That this estimate is less than one suggests that realtors have some information, just not perfect information, that market conditions have deteriorated. In Columns 2-5, I continue to add lagged neighborhood price changes as regressors until the estimated coefficient becomes insignificant. One month price changes immediately before listing have the biggest effect on list price premiums, and the effect of 1 month price changes diminish as they occur further before the month of listing. A price change between month t − 5 and t − 4 does not affect the list price 0 0 premium. It makes sense that the most recent price changes are the least capitalized into list prices because the least information is available about these 17My language suggests that sellers and realtors have the same objective function, even though the empirical evidence suggests otherwise (Levitt and Syverson [2008]). I do not feel that this distinction is important for my analysis since the results are identified off of cross-sectional variation and all of the sellers in my sample use realtors. 11

changes.18 In Table 4, I test how the list price premium varies over the entire distribution of lagged depreciation. The regression specification is 10 (cid:88) pL −pˆ = α +γ + α I[∆4 < d ]+β X +(cid:15) (2) i,j,t0 i,j,t0 j t k ijt k 2 i,j,t i,j,t k=2 where ∆4 = pˆ −pˆ (3) ijt i,j,t0−4 i,j,t0 is the local price change over the four months prior to initial listing, I is the indicator function, and d is the kth decile of the distribution of ∆4 across k all the listings in my sample.19 As shown in Table 4, the higher the lagged price depreciation, the higher the list price, and the relationship is monotonic over the entire ∆4 distribution. Coefficients in bold denote cases where the difference in the coefficient relative to the coefficient in the decile immediately below is statistically significant. The results are similar in column 2, where I restrict the sample only to listings that eventually sell.20 3.2 Expectation Bias and Selling Outcomes The previous section showed evidence that sellers set higher list prices when their local market is declining at a faster than average rate. I interpret this as expectation bias. In this section, I test whether market deterioration affects other variables such as the sales price and marketing time. Here, I find patterns that are consistent with expectation bias, but not with other plausible explanations for the list price results. Columns 3 and 4 of Table 4 substitute TOM as the dependent variable in equation (2) using the full sample and the sample of only sales, respectively. 18The results are similar when I restrict the sample to listings that sell. 19d denotes the largest price declines. The median value of ∆4 is 6 percent. 10 20To test the robustness of these results to my assumption about off-market properties describedinSection2,Irantheseregressionstreatingeachlistingwheretheaddressdoesnot appearinthedatasetintheweekprior,asanewlisting. Theresultsarelargelyunchanged. In Table 3, the coefficient on pˆ −pˆ becomes marginally significant. i,j,t0−5 i,j,t0−4 12

TOM is increasing in ∆4, although the extreme decile of the price change distribution appears to be an outlier. Column 5 shows that the propensity to withdraw is also increasing in ∆4, and monotonic over the entire ∆4 distribution. In this specification, I include in X an additional control for the change in price level during the marketing period, pˆ −pˆ , where T denotes the i,j,T i,j,t0 time period that the house sells or is withdrawn. Column 6 reports results where the dependent variable is the log sales price normalized by the predicted log sales price in the month of sale, i.e. psale − pˆ . Sales prices are significantly decreasing in the lower deciles of i,j,T i,j,T ∆4, but are flat or slightly increasing in the higher deciles. 3.3 Discussion That higher lagged depreciation leads to longer marketing time and a higher propensity to withdraw is consistent with the expectation bias interpretation. Biased beliefs lead to higher reservation prices, which should increase marketing time in a standard search model. Biased beliefs may also draw sellers into the market, only to withdraw later once they realize that their home will not sell for what they initially expected. The theoretical effect of inflated beliefs on sales price is ambiguous. For example, a high reservation price could cause sellers to stay on the market for longer, which allows them to sample more offers and ultimately receive a higher price at the expense of a longer time to sale. Inflated beliefs can also decrease sales prices if, for example, motivation to sell increases over time (e.g. there is a finite selling horizon). In this case, the seller is pricing too high, and potentially turning off potential buyers, exactly when he is most likely to accept higher offers. For this reason, the sales price results alone do not tell us much about the existence of expectation bias. However, the fact that for some regions of the price decline distribution, list prices are significantly increasing while sales prices are significantly decreasing is an unusual pattern that is consistent withexpectationbiasbutinconsistentwithalternativeexplanationsforthelist 13

price, TOM and withdrawal results. A stylized case of this crossing property is illustrated in Figure 1. Finding a reasonable model where an omitted variable from equation (2) increases list prices above what is expected while decreasing salespricebelowwhatisexpectedisachallenge. Infact, findingamodelwhere avariableincreaseslistpricesandleadstonochangeinsalesprice, whichisthe case for much of the ∆4 distribution, is also difficult. For example, standard models of the home selling problem, including the model we present below, predict that unobservables such as high home quality, low motivation to sell, loss aversion, and equity constraints should all lead to higher list and higher sales prices.21 Appendix A.3 presents additional results that are consistent with the conclusions established in this Section. 4 Model 4.1 Overview and Comparison with Related Literature The heart of my model is similar to Carrillo [2010], Horowitz [1992], Salant [1991]. The seller’s decision to list the home and sell it is taken as given, and the seller’s objective is to maximize the selling price of the house less the holding costs of keeping the home on the market. My main contribution is to introduce uncertainty and Bayesian learning into this framework. This makes the home selling problem nonstationary; unlike in Carrillo [2010] and Horowitz [1992], sellers in my model will adjust their list prices over time and the hazard rate of selling varies over time as learning occurs.22 I endogenize the effect of informationonmarketdynamicswhile1)onlyintroducingparametersthatare identifiedgiventhedatasetdescribedinSection2and2)capturingthekeyfeatures of the home selling process including search, a posting price mechanism, preference heterogeneity, and duration dependence in optimal seller behavior. 21Genesove and Mayer [2001] and Anenberg [2011a] present empirical evidence that loss aversion and equity constraints, which may be positively correlated with ∆4, lead to higher list and higher sales prices 22Salant [1991] introduces nonstationarity into the search problem with a finite selling horizon, although sales prices in his model never differ from the asking price and he does not estimate his model. 14

I discuss extensions to the model and their implications for my conclusions in Section 8. The way that I model uncertainty and learning is similar to the existing empirical learning models (see cites in footnote 7)), but my model is unique in two ways. First, I allow the parameter, µ, that agents are learning about to change over time. Second, agents in my model receive direct signals about the unknown parameter (i.e. µ + noise) as in the existing studies, but also receive signals (when buyers do not inspect their house) that the unknown parameter is below a known threshold (i.e. µ + noise < T). The latter innovation introduces some new computational challenges that I discuss in Section 4.5. 4.2 Offer Process and Buyer Behavior At the beginning of each week t that the house is for sale, seller/house combination i selects an optimal list price, pL. This list price and a subset of the it characteristics of the house are advertised to a single risk-neutral potential buyer. From now on, I refer to these potential buyers as simply buyers. The logarithm of each buyer j’s willingness to pay (or valuation) v is parameterijt ized as v = µ +η (4) ijt it ijt where µ is common across all buyers and η represents buyer taste heteroit ijt geneity. The distribution of buyer valuations is exogenous to the model. I assume that η ∼ N(0,σ2). (5) ijt η That is, η is iid across time, houses, and buyers. The advertisement only provides the buyer with a signal of their valuation. From the advertisement, the buyer forms beliefs about v that are assumed buyer beliefs: v ∼ N(vˆ ,σ2) (6) ijt ijt vˆ where vˆ is drawn from N(v ,σ2). Thus, buyers get an unbiased signal of ijt ijt vˆ 15

their true valuation from the advertisement.23 After observing vˆ , the buyer decides whether to inspect the house at ijt some cost, κ.24 If the buyer inspects, then v is revealed to both the buyer and the seller. If v < pL, the seller has all the bargaining power and has the right to make a ’take it or leave it’ offer to the buyer at a price equal to v (which I assume the buyer will accept). If v > pL, then the buyer receives some surplus: the buyer has the right to purchase the house at a price equal to the list price. If the buyer chooses not to inspect or if the buyer’s valuation lies below the seller’s continuation value of remaining on the market, then the buyer departs forever and the seller moves onto the next period with her house for sale. Theproofofthefollowingtheorem, whichcharacterizesthebuyer’soptimal behavior, appears in Appendix A.4. Theorem 1 The optimal search behavior for the buyer takes the reservation value form. That is, the buyer inspects when vˆ > v¯, and does not inspect otherwise. v¯ = T∗ +pL where T∗ is a function of the parameters (κ,σ2). vˆ This price determination mechanism delivers a closed form relationship between v¯ and the list price, which is necessary to keep estimation tractable given that the list price choice will be endogenous. Since the buyer receives no surplus when v < pL, v¯does not depend on the seller’s reservation price or any other variable (like TOM) that provides a signal about the seller’s reservation price. This simple model of buyer behavior endogenizes the list price and leads to a trade-off (from the seller’s perspective) when setting the list price between sales price and TOM.25 The model also generates a mass point at the list price in the sales price distribution. These predicts are consistent with the empirical 23This specification of beliefs would arise if buyers had flat priors (i.e. prior variance = ∞) and processed the signal, vˆ, according to Bayes’ rule. 24The inspection cost should be interpreted broadly as the cost of making a serious offer, including the inspection itself and the opportunity costs of lost time. 25ThewaythelistpricemechanismworksinCarrillo[2010]isasfollows. Withexogenous probabilityθ,thelistpriceservesanatake-it-or-leave-itoffertothebuyer. Withprobability (1−θ), the buyer can make an offer that extracts the entire surplus from the transaction. 16

evidence, and with the theoretical literature on the role of asking prices as a commitment device.26 4.3 The µ process The underlying valuation process, µ , is exogenous to the model. It is not it affected by the individual decisions of the buyers and sellers that I model.27 I assume that it follows a random walk with drift, so that there is no predictability in changes in housing market fundamentals. In other words, in a frictionless environment, there should be no predictable returns to owning a house. The particular parametrization I use in estimation is µ −µ = γ +(cid:15) . (7) it it−1 0 it where (cid:15) ∼ N(0,σ2). (cid:15) 4.4 Structure of Information Iassumethatthesellerknowsalloftheparametersthatcharacterizethesearch problem except for the mean of the valuation distribution, µ . When sellers it receive an offer, they cannot separately identify η from µ. That is, sellers have difficulty distinguishing a high offer due to high average demand from a high offer due to a strong idiosyncratic taste for the house. Sellers have rational expectations about the µ process in (7). Sellers do not observe the realizations of (cid:15), but they observe an unbiased signal z parameterized as z ∼ N(µ −µ ,σ2). (8) it it it−1 z The source of this signal is exogenous to the model, but we can think about it as idiosyncratic information about real-time market conditions that realtors can collect as professional observers of the market. 26See for example Glower et al. [1998], Merlo and Ortalo-Magne [2004], Chen and Rosenthal [1996]. 15 percent of sales occur at the list price in my data. 27In other words, sellers are price takers in this model. 17

To summarize, there are three sources of information that sellers receive during the selling horizon. Sellers observe whether or not a buyer inspects. This reveals whether or not a noisy signal of a buyer’s valuation exceeds a known threshold. Secondly, sellers observe the buyer’s valuation if the buyer inspects. Thus, inspections are more informative to the seller than non-inspections. Since the choice of list price affects whether or not a buyer inspects, the list price has an endogenous effect on the flow of information. I am not aware of other models where the optimal list price will depend on the amount of information that the buyer response to the price is likely to provide. Finally, each period sellers observe the exogenous signal about changes in the valuation process. Appendix A.5 shows how sellers update their beliefs with this information using Bayes’ rule. The final piece of the information environment is the seller’s initial prior, which is assumed to be: initial prior: µ ∼ N(µˆ ,σˆ2). (9) it0 it0 The mean of the prior is given by (cid:80)4 µ (cid:80)8 µ (cid:80)4 µ µˆ = θ ( j=1 t0−j −µ )+θ ( j=5 t0−j − j=1 t0−j )+ it0 1 4 t0 2 4 4 (cid:80)12 µ (cid:80)8 µ (cid:80)16 µ (cid:80)12 µ θ ( j=9 t0−j − j=5 t0−j )+θ ( j=13 t0−j − j=9 t0−j )+ν (10) 3 4 4 4 4 4 it0 where ν ∼ N(µ ,σˆ2). (11) it0 it0 The parameters θ allow the initial beliefs to be sensitive to market conditions from the previous 4 months, as the evidence in Section 3 suggests. If θ = 0 for j = 1,...,4, then the average seller will have unbiased initial beliefs, j although there will still be heterogeneity due to ν. Although I do not explicitly model how this initial prior is generated, I show in Appendix A.7 that if a similar Bayesian learning framework applies prior to the beginning of the 18

selling horizon, then initial priors will depend on lagged information. 4.5 Seller’s Optimization Problem The timing of the model is summarized in Figure 3. Each period begins with the realization of z. The seller updates his beliefs, and then chooses an optimal list price. The list price is set to balance the tradeoffs that emerge from Theorem 1. Once the list price is advertised, the buyer decides whether to inspect, the seller updates the reservation price with the information from buyer behavior, and then the seller chooses to either sell the house (if an offer is made) and receive a terminal utility equal to the log sales price or to move onto the next period with the house for sale. Each period that the home does not sell, the seller incurs a cost c, which reflects discounting and the costs of keeping the home presentable to show to prospective buyers. I impose a finite selling horizon of 80 weeks. The following Bellman’s equation, which characterizes selling behavior at the third hash mark on the timeline in Figure 3, summarizes the seller’s optimization problem: (cid:32) (cid:90) V (Ω ) = max (c+V (Ω |vˆ < T∗ +pL,z ))Pr(vˆ < T∗ +pL) t t t+1 t+1 t t+1 t pL t z (cid:90) pL (cid:2) + max{v ,c+V (Ω |v ,z )} t t+1 t+1 t t+1 −∞ (cid:33) (cid:90) ∞ (cid:3) + pL Pr(vˆ > T∗ +pL)g(v |vˆ > T∗ +pL)dv f(z )dz (12) t t t t t t+1 t+1 pL where Ω denotes the state variables. The normality assumptions imposed t throughout, in addition to an approximation method borrowed from a statistics paper by Berk et al. [2007] on Bayesian learning with censored demand, imply that Ω is comprised of a single mean and variance. The self-conjugacy t of the normal distribution is critical in avoiding the curse of dimensionality 19

that can make dynamic models infeasible to estimate.28 This is discussed in more detail in Appendix A.5. Expectations are with respect to whether vˆ will exceed T∗ +pL, the realization of v, which is correlated with vˆ, and the realization of the signal about demand changes, z. The top line of equation (12) reflects the case when a buyer does not inspect. In this case, the seller updates his beliefs to Ω and moves onto the next period. If vˆ > T∗ +pL, the seller t+1 t receives an offer, v. If the offer is above pL, the payoff is pL. If the offer is below pL, the seller Bayesian updates and then decides whether to accept, or reject and move onto the next period. pL is chosen by the seller to maximize this expected utility. In the Appendix A.5, I show how Ω transitions to Ω t t+1 given the realizations of v, z, and vˆ. 5 Estimation and Identification Table 5 summarizes the notation of all of the model parameters. I estimate the parameters using simulated method of moments. That is, I minimize a weighted average distance between sample moments and simulated moments with respect to the model’s parameters. The weights are the inverses of the estimated variance of the moments. The target moments are listed in Table 6. I calculate the empirical moments using the subset of listings that sell (which introduces potential sample selection issues that I discuss in Section 8). I describe the dynamic programming techniques used to estimate the model in Appendix A.6. The parameters that are not estimated are the time invariant holding cost (c = 0) and the buyer’s inspection cost (κ = −.005 or .5 percent of the list price). The conclusions that follow are related to the parameters that dictate the flow of information, and so I find that my results are not sensitive to the choicesfortheseparameters. Icalibratethemean(γ = −.0033or.33percent) 0 of the µ process using the average monthly change in the Case-Shiller index 28The same normality assumptions are made in most empirical learning models. See, for example, CrawfordandShum[2005]andAckerberg[2003]. Iamnotawareofanyempirical learning models that allow for the type of censored demand that arises when the buyer’s valuation exceeds the list price. 20

for San Francisco and Los Angeles during my sample period. I set θ ,θ ,θ ,θ 1 2 3 4 equal to the coefficients on lagged depreciation estimated in Column 4 of Table 3. Since ∂pL/∂µˆ = 1 in the model (proof not reported), this implies that the initial list price will display the same level of sensitivity to lagged market conditions as found in the data. The variance of the offer distribution, σ2, is identified by the distribution η of sales prices relative to the list price. The level of initial uncertainty, σˆ2, is identified by the size of list price changes, especially in the first couple weeks afterlistingbeforedepreciationinµincreasesthevarianceinlistpricechanges. Both variances also have different predictions for TOM. More variance in the offer distribution increases TOM because the higher incidence of very good offers increases the value of searching. More uncertainty distorts the choice of list price and reservation price, which decreases the returns to staying on the market. The average premium of the list price relative to the sales price helps to identify σ2, as does the propensity for prices to occur at the list price. vˆ For example, if buyers have a lot of information about their valuation prior to inspection (low σ2), sellers need to set low list prices to induce inspections. vˆ σ2 is identified by the correlation between list price changes and changes in z pˆ. A high correlation suggests that σ2 is low because sellers can quickly and z fully internalize changes in market conditions into their list price decisions.29 The variance of the µ process, σ2, is identified by the variance of changes in (cid:15) average prices over time. In the data, I calculate this moment by taking the standard deviation of monthly price changes in the Case-Shiller index for San Francisco and Los Angeles during my sample period. 29If I used weekly list price changes, the model would generate a high σ2 because in most z caseslistpricesdonotchangeweekbyweek. Someofthismaybeduetohighσ2, butsome z of it may be due to menu costs, which I do not model. As a result, I use list price changes intheinitialweekoflistingrelativetothefinalweekoflisting. Menucostsshouldhaveless of an effect on average changes over longer horizons. 21

6 Estimation Results and Model Fit The learning model matches the data well (see Table 6 for the simulated moments at the estimated parameter vector). Even when agents have rational expectations about the severe market decline during my sample period, the model matches the lengthy TOM observed in the data. At the estimated parameters, more uncertainty raises the list price because sellers want to test demand before dropping the price, which will attract more buyers but will also transfer more of the bargaining power to the buyer. Since uncertainty decreases over the selling horizon, the model generates declining list prices, and would do so even if market conditions (i.e. the µ process) were constant. However, as in the data, a minority of list price changes are increases (6 percent in the data versus 4 percent in the model). The fraction of list price changes that are increases is not a moment that I directly target in estimation. In the model, list price increases primarily occur from sellers with low draws of ν in equation (10). Interestingly, the model fits the fact that list to sales price premiums increasewithTOM.Thisistrueeventhoughlistpricesareincreasinginthelevel of uncertainty, and the level of uncertainty decreases over the selling horizon. The reason for the increasing wedge between list and sales prices is selection: sellerswithlowreservationpricestendtosellquicklyandpostlowerlistprices. The model overpredicts the average list price change at delisting relative to listing. This is partly because I do not model menu costs. In Section 8 I discuss the robustness of my results to this and other simplifications. Table 5 reports the parameter estimates and their standard errors.30 The results suggest that sellers typically accept offers that are 12 percent above the mean of the valuation distribution, which is the 92nd percentile. Given that the average sales price is $ 628,000, this implies that the mean of the offer distribution is about $ 561,000 (628000/1.12) for the typical house. Thus, the standard deviation of the seller’s prior for the typical house is about $ 30The variance-covariance matrix of the parameter estimates is given by (G(cid:48)W−1G)−1, where G is the matrix of derivatives of the moments with respect to the parameters and W is the variance-covariance matrix of the moments. Off-diagonal elements are ignored. 22

38,000 and the standard deviation of the offer distribution is about $47,000. I calculate that Bayesian learning reduces the standard deviation (variance) of the seller’s initial prior by 37 percent (60 percent) over the course of the selling horizon. I also relate the predictions of the model to the reduced form results presented in Section 3. As mentioned above, the specification of the initial prior in equation (10) ensures that the model replicates the correlation between lagged price depreciation and list prices observed in the data. The model also predicts that lagged price depreciation is positively correlated with TOM.31 The stronger is perceived demand, the higher is the reservation price, which increases TOM, all else equal. The model predicts a small effect of lagged price depreciation on sales price.32 Just as in the data, for some parts of the distribution of initial bias, more bias leads to lower sales prices. The model predicts that two alternative explanations for the high list prices found in Section 3 – high unobserved home quality (a higher µ) and low unobserved motivation to sell (a higher |c|) – lead to unambiguously higher sales prices as well higher list prices (proof not reported). Thus, the model illustrates how these explanations are inconsistent with the evidence from Section 3. 7 Simulations of Market Dynamics 7.1 Price Dynamics It has been well documented that house price appreciation rates are persistent in the short-run. An important question is whether this predictability can be supported in an equilibrium where market participants are behaving optimally. My model of rational behavior conditional on an exogenous level of information suggests that it can. I show this by simulating average weekly sales prices using the model for T = 48000 and N = 20000 new listings each week. Theparametersofthemodelaresetattheirestimatedvalues. Following 31A 1 percent increase in lagged price depreciation increases TOM by 5.1 percent. 32A 1 percent increase in lagged price depreciation increases sales price by .1 percent. 23

the literature, I run the following regression on the simulated price series p −p = ρ +ρ (p −p )+ν . (13) t t−52 0 1 t−52 t−104 t where p is the log average price over all simulated sales in week t.33 t Table 7 shows the results. The level of sales price persistence generated by the model is .124. The information frictions are completely responsible for the persistence. Column 1 shows that when the average seller has unbiased beliefs at the time of initial listing and when σ = 0, ρ = 0.34 The third and z 1 fourth columns show results when I aggregate weekly prices to the quarterly level. In this case, the dependent variable is p −p where t is a quarter and t t−4 p is the simple average of all sales in quarter t. I present these results because t in practice sales do not occur frequently enough to compute price indexes at the weekly level. Case and Shiller [1989] and Cutler et al. [1991], for example, run their regressions at the quarterly level. The aggregation alone introduces persistence, and the AR(1) coefficient rises to .152. 7.1.1 Discussion, Robustness, and Further Results At the parameter estimates, the model generates persistence that is over half the level typically found in the data. The intuition for the result is as follows. Sellers do not fully adjust their beliefs in time t to a shock to µ in time t, on average. The optimal Bayesian weighting places some weight on the signal about the shock and some weight on the seller’s prior expectation. Then, for example, when there is a positive shock, the average reservation price in the population rises, but is too low relative to the perfect information case. As time progresses, however, learning from buyer behavior provides more information about the shock, and reservation prices eventually fully adjust. The same intuition holds for a negative demand shock. Thus, serial correlation in 33Bysimulatingalargenumberofsaleseachweek,Iavoidmeasurementerrorsthataffect the estimation of these regressions in practice. See Case and Shiller [1989]. 34Recall that the fundamental determinant of house values in the model, µ , follows a t random walk (see equation 7). So by construction, there is zero persistence in changes in the fundamentals. 24

price changes arises because 1) persistent demand shocks are not immediately capitalized into reservation prices and 2) there exists a mechanism through which additional information about these shocks arrives with a lag. Over shorter frequencies, the persistence is even higher, as shown in the right-most columns of Table 7. We can see this through the equation for the OLS estimate of ρ : 1 cov(p −p ,p −p ) t t−L t+L t ρˆ = . (14) 1 var(p −p ) t t−L As the lag length, L, gets smaller, the numerator stays approximately the sameandthedenominatorgetssmallerbecausetherearefewershocksbetween time t and t−L. By the same logic, the persistence dies out as L increases. Thus, the short-run persistence generated here does not preclude long-run mean reversion in price changes, which is an additional stylized fact about house price dynamics. The model can generate long-run mean reversion with the addition of a mean reverting shock to the µ process.35 The persistence generated by the model could be arbitraged away if some traders have superior access to information about the current period fundamentals. However, given that realtors already provide the typical seller with information based on their professional insights and access to data in the MLS, this seems like a difficult arbitrage. In addition, the difficulty in taking short positionsandthelargetransactioncostsinvolvedintradinghomescomplicates any potential trading strategy (Meese and Wallace [1994]). σ2 potentially plays a large role in determining the amount of persistence z because it affects how much of a demand shock is immediately capitalized into reservation prices. When σ2 is high, there is a lot of scope for persistence z because most of the information about the demand shock will arrive with a lag. To test the sensitivity of the results in Table 7 to the point estimate of σ2, I re-simulate the model at the upper and lower limits of the 95 percent z confidence interval for the estimate of σ . The annual persistence (weekly z 35Glaeser and Gyourko [2006] cannot generate short-run momentum, but generate longrunmeanreversionwithameanrevertingshocktolocalproductivityandaslowconstruction response. 25

prices) always lies between 0.12 and 0.13. Given that σ = .018 (1.8 percent) z at the lower end of the confidence the interval, the model does not require much signal noise at all to generate a significant amount of persistence. I also test the sensitivity of the results to the assumption that the mean of the valuation distribution, µ , changes each period (i.e. each week). I simulate t a version of the model where µ only changes every four periods; I multiply σ2 t (cid:15) by four so that the variance of µ −µ is the same as in the baseline model. t t−4 In this version of the model, the annual persistence is slightly higher at .131 for weekly prices and .162 for quarterly prices. 7.2 Sales Volume and TOM Dynamics The existing literature has identified frictions related to search and credit constraints as explanations for the positive price-volume correlation in the housing market. In this section, I show that an information friction is an additional contributor to this correlation. Table 8 shows the results when I regress log(Volume) and log(TOM) on quarterly price changes using data simulated from the model at the estimated parameters. Column 1 shows that a 1 percent increase in quarterly prices leads to a 6.7 percent increase in sales volume. The estimate from running the same specification on the actual data for Los Angeles and San Francisco is 5 percent, which is close to the estimate reported in Stein [1995] who uses data from the entire US housing market.36 Column 2 shows that absent the information friction, the model does not predict a relationship between price changes and volume. When the dependent variable is log(TOM), the model generates a β = 1 −7.6: a 1 percent increase in quarterly prices leads to a 7.6 percent decline in TOM.37 To compare this prediction to the data, I collect a TOM time- 36Toestimatethisregressiononthedata,Ifirstrunarepeatsalesregressionwithquarter dummies on the transaction data from 1988-2009. The change in the quarter dummies (adjusted for inflation) is then the explanatory variable in an OLS regression where volume isthedependentvariable. IruntheregressionsseparatelyforLosAngelesandSanFrancisco, but the estimates are similar. 37Intheversionofthemodelwhereshocksarriveonlyonceamonth, β =−6.3forTOM 1 26

series from the Annual Historical Data Summary produced by the California Association of Realtors. The TOM data reflects averages for the entire state of California, while the quality adjusted price data I have is from Los Angeles and San Francisco so the comparison is quite rough. The estimate of β is -5.6 1 percent using LA prices and -4.1 percent using SF prices, suggesting that the model is generating predictions that are of the same order of magnitude as the empirical price-TOM relationship. The results suggest that information frictions are important for explaining variation in transaction rates over the housing cycle. The intuition for these results is that positive shocks to home values are accompanied by reservation prices that are too low relative to the perfect information case. Lower reservationpricesrelativetothefundamentalsleadstomoreandquickertransactions. 8 Discussion of Model Assumptions In this section, I discuss the robustness of the results to a few stylized features of the model. 8.1 No Buyer Learning In the model, changes in the offer, or willingness to pay, distribution are exogenous. Amodelthatendogenizesbuyerwillingnesstopayfromthefundamental demand and supply conditions in the economy could also include a dynamic learning process, as the thinness and volatility of the market probably make it difficult for buyers to observe market conditions as well. We do not model such a dynamic process because it would be difficult to identify without data on buyer behavior and it would significantly complicate the seller’s problem. However, I suspect that including a buyer learning process would increase the level of price persistence. In the current setup, reservation prices adjust to market shocks with a lag, but offers adjust immediately. If offers adjust with a lag as well, then the adjustment of prices to market shocks would be and β =7.3 for volume. 1 27

even slower. The correlations between volume and TOM with price changes, however, may be attenuated because sluggish reservation prices are met with sluggish demand. 8.2 Abstraction from Features of the Micro Data The model presented above is the simplest version of an empirical model needed to highlight the effects of information frictions on market dynamics. As a result, the current version of the model does not explain some features of the micro data such as withdrawals, sales prices above list prices, and sticky list prices.38 In a working paper version of the paper Anenberg [2011b], I experimented with more detailed versions of the model to address each of these features. The main conclusions are unchanged. In this section, I summarize these adjustments to the model. To accommodate withdrawals, I allow sellers to withdraw at any time and receive an exogenous and heterogenous termination utility, vw. The parameter estimates from that model suggest that there is a group of motivated sellers, with very low vw as modeled above, and a group of unmotivated sellers with high vw. Hardly any of the unmotivated sellers end up selling given the decline in the market. Thus, the predictions of the model with respect to sales price and volume dynamics are similar.39 This version of the model requires positive holding costs, c, to explain why sellers do not stay on the market indefinitely. The estimated holding costs are small. To accommodate sales prices above the list price, I assume that when v > pL, there is some exogenous probability that the price gets driven up above pL. This addition to the model does not affect the main parameter estimates or conclusions. 38The models of Carrillo [2010] and Horowitz [1992] do not accommodate these features of the data either. 39Ialsonoteherethatuncertaintyisabletorationalizethehighwithdrawalrateobserved in the data. The estimated amount of uncertainty is high enough and the holding costs of keeping a home on the market are low enough that unmotivated sellers find it optimal to test the market even though they fully anticipate withdrawing if they learn that demand for their house is insufficient. 28

The current model predicts that sellers should adjust their list price, oftentimes by an (cid:15) amount, each period. This is one reason that the model overpredicts the average list price change at delisting relative to listing. In practice, list prices are sticky, presumably due to menu costs. In the working paper version of this paper, I show that very small menu costs can rationalize sticky list prices. Thus, I do not expect the addition of a menu cost, which would significantly increase the computational burden, to affect the conclusions. 8.3 One Offer per Period In the model I assume that the expected amount of information that the seller receives does not vary much over the selling horizon. In practice, the arrival of buyers may be especially strong in the first several periods while the listing is fresh. Thus, learning in the initial weeks may be higher than the model allows for. Modeling multiple offers significantly complicates estimation, and it is not clear how the arrival rate would be identified without information on buyer behavior. Instead, I test the robustness of my results to stronger learning in the initial weeks by allowing sellers to observe an additional draw from the offer distribution, v , during each period in the first month after listing. The it annual price persistence declines from .124 to .092. The effect of price change on volume decreases from 6.7 percent to 3.3 percent, and the effect of price change on TOM increases from -7.6 percent to -5.8 percent. 9 Conclusion Thispapershowsthatinformationfrictionsplayanimportantroleintheworkings of the housing market. Using a novel and robust identification strategy for expectation bias, I find direct evidence that imperfect information affects the micro decisions of individual sellers. Then, I show that a search model with uncertainty and Bayesian learning fits the key features of the micro data remarkably well, suggesting that information frictions are important in ex- 29

plaining the distribution of marketing times, the role of the list price, and the microstructure of the market more generally. I also use the model to highlight how micro-level decision making in the presence of imperfect information affects aggregate market dynamics. Most notably, I find a significant microfounded momentum effect in short-run aggregate price appreciation rates. The analysis here raises several interesting directions for future research. Given the sample period that I have access to, I have argued that my results likely characterize market dynamics during cold housing markets. Since the basic mechanisms generating the main results do not depend on the market beingindecline, Isuspectthatmy model, estimatedusingasamplewithrising prices, would be successful in explaining momentum and correlations between price, volume, and marketing time in rising markets as well. However, the magnitude of the results may differ as the pace of learning may change over the housing cycle. This paper does not discuss the welfare implications of uncertainty. In a working paper version, I use a similar model to show that the value of information to sellers is large, which helps to explain the demand for realtors that typically charge 3 percent of the sales price. On the modeling side, extending micro models of the home selling problem to the multi-agent setting, so that the pricing and selling outcomes of neighboring listings has an endogenous effect on the flow of information, is an interesting direction for future research. References Daniel A. Ackerberg. Advertising, learning, and consumer choice in experience good markets: An empirical examination. International Economic Review, 44(3):1007–1040, 2003. Elliot Anenberg. Loss aversion, equity constraints and seller behavior in the real estate market. Regional Science and Urban Economics, 41(1):67 – 76, 2011a. 30

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A Appendix: For Online Publication A.1 Data Appendix I first describe how I combine the listing data from Altos Research with the transaction data from Dataquick. I begin by cleaning up the address variables in the listing data. The address variables in the transaction data are clean and standardized because they come from county assessor files. The listing data contains separate variables for the street address, city, and zip code. I ignore the city variable since street address and zip code uniquely characterize houses. The zip code variable does not need any cleaning. In a large majority of cases, the address variable contains the house number, the street name, the street suffix, and the condo unit number (if applicable) in that order. We alter the street suffixes to make them consistent with the street suffixes in the transaction data (e.g. change ”road” to ”rd”, ”avenue” to ”ave”, etc). In some cases, the same house is listed under 2 slightly different addresses (e.g. ”123 Main” and ”123 Main St”) with the same MLSIDs. We combine listings where the address is different, but the city and zip are the same, theMLSidsarethesame, thedifferenceindatesbetweenthetwolistings is less than 3 weeks, and at least one of the follow conditions applies: 1. The listings have the same year built and the ratio of the list prices is greater than 0.9 and less than 1.1. 2. The listings have the same square feet and the ratio of the list prices is greater than 0.9 and less than 1.1. 3. Thelistingshavethesamelotsizeandtheratioofthelistpricesisgreater than 0.9 and less than 1.1. 4. The first five characters of the address are the same. We merge the listing data and the transaction data together using the address. If we get a match, we keep the match and treat it as a sale if the difference in dates between the transaction data (the closing date) and the date the listing no longer appears in the MLS data (the agreement date) is greater than zero and less than 365 days. If the match does not satisfy this timing criteria, we keep the most recent transaction to record the previous selling price. Before we do the merge, we flag properties that sold more than once during a 1.5 year span during our sample period. To avoid confusion during the merge that can arise from multiple sales occurring close together, 35

we drop any listings that merge to one of these flagged properties (< 1 percent of listings). I drop listings where the ratio of the minimum list price to the maximum list price is less than the first percentile. I drop listings where the TOM is greater than the 99th percentile. I drop listings where the list to predicted price ratio is less than the 1st or greater than the 99th percentile. I drop listings where the predicted price is less than the 1st or greater than the 99th percentile. I drop listings where the sales to predicted price ratio is less than the 1st or greater than the 99th percentile. A.2 Detail on Calculation of Predicted Prices pˆ is the log expected sales price for house i in month t. This expected it price is simply equal to the previous log price paid for the house plus some neighborhood (zip code in this analysis) level of appreciation or depreciation. To calculate the level of appreciation, I follow Shiller [1991], who estimates the following model p∗ = v +δ +(cid:15) (15) ijt i jt ijt where v is a house fixed effect, δ is a neighborhood specific time dummy, and jt (cid:15) is an error term. We can estimate the coefficients on the neighborhoodijt specifictimedummies,whichformthebasisofaqualityadjustedneighborhood index of price appreciation, through first-differencing and OLS using a sample of repeat-sales. In practice, when I estimate the time-dummy coefficients for a particular zip code j, I use the entire sample of repeat sales from 1988-2009, except I weight the observations for zip code i using (cid:20) 1 dist (cid:21)1/2 ij W = φ( ) (16) i(j) h h∗std(dist ) ij where φ is the standard normal pdf, dist is the distance between the centroid of the zip codes i and j, and h is a bandwidth.40 I use this weighting scheme because sometimes the number of sales in a particular zip code in a particular month is not large. 40I set the bandwidth equal to 0.25. This choice of bandwidth implies that the weights decline about 40 percent as we move 10 miles away from the centroid of a neighborhood. The main results of the paper are robust to alternative choices of bandwidth. 36

A.3 Further Results on Expectation Bias Appendix Table 1 presents additional results that are consistent with the conclusions established Section 3. I test whether sellers in neighborhoods where there have been a lot of recent sales are better able to detect recent price trends. In the context of the model, we could think of these sellers as receiving signals, z, with a tighter variance because there is more information about recent price trends. We run the following variation of specification (2) y = γ +β ∆4 +β ∆4 ∗sales +β X +(cid:15) (17) i,j,t t 1 jt 2 jt jt 3 i,j,t i,j,t where sales is the total number of sales in neighborhood j in the previous jt 4 months. Column 1 of Appendix Table 1 shows that a 1 standard deviation increase in sales lowers the effect of ∆4 by 0.12, or 22 percent. Columns jt jt (2)-(4) show the results when we substitute TOM, I[Withdraw], and the sales price premium as the dependent variable.41 More thickness decreases the positive (negative) effects of lagged depreciation on TOM (sales price). The effects on the propensity to withdraw are economically insignificant. Column (5) shows that the effects of ∆4 on list prices diminish as we move jt later in the sample period. The time series of prices in Figure 2 provides a likely explanation. As the housing decline deepened and sellers learned that prices were depreciating rapidly, they did a better job of adjusting the prices of recent comparable sales for the downward trend. A.4 Proof of Theorem 1 Buyers will inspect house i when the expected surplus from visiting exceeds the expected cost, i.e. when (cid:90) ∞ 1 v −vˆ (v −pL) φ( )dv ≥ −κ (18) σ σ pL vˆ vˆ where φ is the standard normal distribution. The lower limit of integration is pL because the buyer receives no surplus when her valuation is below the list price. Toshowthattheoptimalbuyerbehaviortakesthereservationvalueform,it is sufficient to show that the term in the integral in equation (18) is increasing in vˆ. Using properties of the truncated normal distribution, we rewrite the 41The adjustments to the regressors in (17) depending on the dependent variable follow the discussion/specifications in Section 3. In these specifications where we have no controls for neighborhood, we also include an additional control for the level of sales . jt 37

integral as pL −vˆ pL −vˆ (vˆ−pL)(1−Φ( ))+σ φ( ) (19) vˆ σ σ vˆ vˆ Taking the derivative of this expression with respect to vˆ gives pL −vˆ pL −vˆ pL −vˆ pL −vˆ (1−Φ( ))+(vˆ−pL)φ( )+(pL−vˆ)φ( ) = 1−Φ( ) > 0. σ σ σ σ vˆ vˆ vˆ vˆ (20) To show the particular form of v¯, using properties of the truncated normal distribution, we rewrite equation (18) for vˆ = v¯ as pL −v¯ pL −v¯ (v¯−pL)(1−Φ( ))+σ φ( )+κ = 0. (21) vˆ σ σ vˆ vˆ Let z be the left hand size of (19). It is clear from (19) that ∂z = −∂z. ∂pL ∂v¯ Then, using the implicit function theorem, ∂v¯ = 1. Thus, the remaining ∂pL determinantofv¯willbeanadditivelyseparableterm, T∗. Togetanexpression for T∗, plugging the solution for v¯ into (19), we get −T∗ −T∗ (T∗)(1−Φ( ))+σ φ( )+κ = 0. (22) vˆ σ σ vˆ vˆ Given values for (σ ,κ), we can solve for T∗ using fixed-point iteration. vˆ A.5 Model Details on Learning In this section, we detail how sellers update their beliefs in response to information that arrives during the selling horizon. Define the following means and variances of seller beliefs over µ : it µˆpre,σˆpre : Beliefs after observing z but before observing buyer behavior in week t. it it µˆ ,σˆ2 : Beliefs after observing buyer behavior in week t. it it Supposethatµˆ andσˆ2 arethemeanandvarianceofanormaldistribution it it atanytimet. Giventheassumptionsmadeinthemodel,Ishowbelowthatthis will be the case. Then, Bayes’ rule implies that the posterior after processing z is also normal where σ2µˆ +σˆ2z µˆpre = µˆ + z p p it it it−1 σ2 +σˆ2 z p 38

σ2σˆ2 σˆpre = σˆ2 + z p . (23) it it−1 σ2 +σˆ2 z p The best case scenario for the seller is that σ2 = 0; in this case, weekly changes z to the mean of the valuation distribution do not increase uncertainty. The source of learning that decreases uncertainty in week t is buyer behavior. If a buyer arrives, recall that the seller observes v , which is a noisy signal it of µ . The posterior distribution of µ after the seller processes the information it in v remains normal with mean and variance at time t given respectively by: it σ2µˆpre +σˆprev µˆ = η it it it it σ2 +σˆpre η it σˆpreσ2 σˆ2 = it η . (24) it σˆpre +σ2 it η The initial conditions are given in equation (9). If a buyer does not arrive, the seller observes that vˆ < T∗ +pL and the it it density function of the posterior is Φ(T√∗+pL−µˆt)φ(µˆt−µˆp t re ) 1 f(µˆ |vˆ < T∗ +pL) = σ η 2+σ v 2 ˆ σˆ t pre σˆ t pre . (25) t Φ(√T∗+pL−µˆp t re ) σˆpre+σ2+σ2 t η vˆ This is not a normal distribution because of the µˆ term in the normal cdf in t the numerator. A statistics paper by Berk et al. [2007] shows that a normal distribution with mean and variance equal to the mean and variance of the distribution in equation (25) is a good approximation for the true posterior when demand is censored in exactly this way. I use this approximation method here, noting that simulations show this approximation to work extremely well for my application. Then, when a buyer does not arrive, the posterior distribution after processing that vˆ < T∗ +pL is normal with mean and variance it it at given respectively by: µˆ = µˆpre −σˆpreh(T∗ +pL) it it it 1 σˆ2 = ((µˆpre)2σ4 +τσˆpreσ2 +2σˆpreσ2(µˆpre)2 +(σˆpre)2τ +(µˆpre)2(σˆpre)2) it τ2 it it it it it it it +(2µˆpreσˆpreσ2 +(σˆpre)2(T∗ +pL +µˆpre))−h(T∗ +pL)/τ −(µˆ )2 (26) it it it it it where τ = σˆpre+σ2+σ2, σ2 = σ2+σ2, and h is the hazard rate corresponding it η vˆ η vˆ 39

to the normal distribution with mean µˆpre and variance τ. it A.6 Dynamic Programming Methods I assume a finite horizon of 80 weeks for the selling horizon. It is well known that in these types of dynamic programming problems, V from equation (12) needs to be calculated for each point in the state space. I calculate V for a discrete number of points and use linear (in parameters) interpolation to fill in the values for the remainder of the state space. The integrals in equation (12) have a closed form. No simulation is required. This avoids a source of bias that often arises in practice when the number of simulations required to preserve consistency is not feasible to implement. See Keane and Wolpin [1994] for a more detailed discussion. The closed form arises due to the normal approximation for the pdf, g, described in Berk et al. [2007], properties of the truncated normal distribution, the absence of idiosyncratic choice specific errors from the model, linearity in equations (23) and (24), and linearity in the interpolating function. The optimal list price, however, does not have a closed form. For each point in the discretized state space, I solve for the optimal list price using a minimization routine. The optimal list price also needs to be calculated when simulating selling outcomes for each seller. I approximate the list price policy function using linear (in parameters) interpolation. This is done using the discrete points used to approximate the value function. A.7 Bayesian Learning Prior to Listing In this section, I show that if a similar Bayesian learning framework applies prior to the beginning of the selling horizon, the initial priors will depend on lagged information. To see how, consider a simplified information structure where µ follows a random walk with a drift equal to zero (and normally t distributed shocks). Furthermore, assume that µ is observable, but the t0−1 seller only gets a signal z about µ − µ . Then, the seller’s beliefs about t0 t0−1 µ will be t0 µ +θz (27) t0−1 where θ = σ (cid:15) 2 is the optimal Bayesian weight that sellers put on the signal. σ2+σ2 (cid:15) z For a realization of µ < 0, sellers will tend to overstate µ on average. This t0 t0 will lead to high list prices because the optimal list price is monotonic in µˆ as discussed above. The noisier the signal z, the lower is θ, and the more sellers will overstate µ for low realizations of µ . t0 t0 40

Figure 1: Test for Expectation Bias t 0 Time ecirP Time Note: Black and grey denote 2 different neighborhoods. The solid lines denote the average sales prices among all homes in the neighborhood that sell at each point in time. Average list price for homes first listed for sale at month t 0 Average sales price for homes first listed for sale at month t 0 eecciirrPP Figure 2: Case Shiller Home Price Index 2007-2009 1.1 1 0.9 ecirP Figure 2: Case Shiller Home Price Index 2007-2009 1.1 1 0.9 0.8 0.7 0.6 0.5 0.4 ecirP Figure 2: Case Shiller Home Price Index 2007-2009 1.1 1 0.9 0.8 0.7 0.6 0.5 0.4 San Francisco Los Angeles

Figure 3: Timeline of Events in Model Seller gets Buyer gets signal, z, about signal, chooses Seller updates If offer made, Seller repeats μ - μ ; seller Seller whether to beliefs from seller decides to process if reject t t-1 Pay cost c updates beliefs chooses pL inspect buyer behavior accept or reject chosen in time t t t+1

Table I : Summary Statistics List Price - Predicted Price Square Feet Year Built Time on Market Change in List Price Sales Price (%) (Weeks) over Selling Horizon Mean 8% 1683 1961 18 -10% 628372 Sell p25 -5% 1188 1950 5 -14% 360000 N= 87,879 p50 6% 1513 1960 12 -2% 530000 p75 18% 1999 1980 25 0% 765000 Mean 17% 1673 1960 20 -7% Withdraw p25 2% 1156 1949 8 -9% N=88,060 p50 14% 1495 1958 16 -1% p75 28% 2032 1979 26 0% Mean 12% 1678 1960 19 -9% 628372 Total p25 -2% 1172 1949 6 -11% 360000 N=175,939 p50 9% 1504 1959 14 -2% 530000 p75 23% 2014 1979 26 0% 765000 Notes: The Predicted Price is calculated by applying a neighborhood level of sales price appreciation to the previous log selling price.

Table 2: Percent of Sellers on Market that Adjust List Price by Week Since Initial Listing Weeks Since % Adjusting Listing List Price 1 4.47% 2 7.72% 3 9.91% 4 11.21% 5 11.42% 6 10.82% 7 10.20% 8 10.27% 9 10.47% 10 10.26% 11 10.04% 12 9.78% 13 9.88% 14 9.86% 15 8.91% 16 8.97% 17 8.95% 18 9.24% 19 8.99% 20 8.92% 21 8.83% 22 8.69% 23 8.68% >=24 9.54%

Table 3: Effects of Lagged Market Conditions on List Price (1) (2) (3) (4) (5) Log List Price‐ Log List Price‐ Log List Price‐ Log List Price‐ Log List Price‐ Dependent Variable Log Predicted Price Log Predicted Price Log Predicted Price Log Predicted Price Log Predicted Price Log Predicted Price ‐ Log Predicted Price 0.5631*** 0.7052*** 0.7298*** 0.7439*** 0.7475*** t‐1 t (0.0266) (0.0327) (0.0347) (0.0367) (0.0381) Log Predicted Price ‐ Log Predicted Price 0.3933*** 0.4858*** 0.5167*** 0.5298*** t‐2 t‐1 (0.0321) (0.0415) (0.0473) (0.0534) Log Predicted Price ‐ Log Predicted Price 0.2262*** 0.3071*** 0.3238*** t‐3 t‐2 (0.0366) (0.0548) (0.0644) Log Predicted Price ‐ Log Predicted Price 0.1583*** 0.1999*** t‐4 t‐3 (0.0478) (0.0741) Log Predicted Price ‐ Log Predicted Price 0.0771 t‐5 t‐4 (0.0570) Month fixed effects X X X X X Zip code fixed effects X X X X X Observations 175939 175939 175939 175939 175939 Adjusted R‐squared 0.111 0.113 0.113 0.114 0.114 *** p<0.01, ** p<0.05, * p<0.1 Notes: The Predicted Price is calculated by applying a neighborhood level of sales price appreciation to the previous log selling price. The t in the subscript of the explanatory variables denotes the month of initial listing. Regressions also include a Real Estate Owned dummy. Standard errors clustered at the zip code level are in parentheses.

Table 4: Effects of Lagged Market Conditions on Selling Outcomes (1) (2) (3) (4) (5) (6) Log List Price‐ Log List Price‐ Log Sales Price‐ Dependent Variable Log Predicted Price Log Predicted Price TOM TOM Withdraw Log Predicted Price Distribution of Price Depreciation Rates: 2nd decile 0.0196*** 0.0111** 2.8823*** 3.0797*** 0.0499*** ‐0.0171*** (0.0048) (0.0047) (0.3819) (0.4404) (0.0099) (0.0033) 3rd decile 0.0226*** 0.0121** 3.7888*** 3.9170*** 0.0828*** ‐0.0245*** (0.0046) (0.0049) (0.4001) (0.4555) (0.0109) (0.0034) 4th decile 0.0279*** 0.0132*** 3.9401*** 4.4235*** 0.0983*** ‐0.0291*** (0.0048) (0.0051) (0.4131) (0.4910) (0.0111) (0.0034) 5th decile 0.0447*** 0.0308*** 4.5446*** 5.4883*** 0.1151*** ‐0.0227*** (0.0052) (0.0054) (0.4038) (0.4982) (0.0104) (0.0035) 6th decile 0.0490*** 0.0371*** 4.7441*** 5.5356*** 0.1199*** ‐0.0197*** (0.0054) (0.0059) (0.4716) (0.6070) (0.0112) (0.0036) 7th decile 0.0474*** 0.0364*** 4.6186*** 5.7616*** 0.1250*** ‐0.0224*** (0.0056) (0.0059) (0.5134) (0.6659) (0.0119) (0.0037) 8th decile 0.0588*** 0.0474*** 4.4823*** 4.7369*** 0.1505*** ‐0.0172*** (0.0057) (0.0061) (0.5507) (0.6548) (0.0118) (0.0038) 9th decile 0.0657*** 0.0553*** 4.9347*** 5.2629*** 0.1621*** ‐0.0157*** (0.0063) (0.0065) (0.5504) (0.6645) (0.0124) (0.0040) 10th decile 0.0927*** 0.0815*** 3.5064*** 2.9475*** 0.1672*** 0.0088** (0.0087) (0.0091) (0.5506) (0.6505) (0.0135) (0.0042) Change in Predicted Price over Selling Horizon ‐0.5106*** (0.0369) Month fixed effects X X x x x x Zip code fixed effects X X Only Listings that Sell x x x Observations 175939 87879 175939 87879 175939 87879 Adjusted R‐squared 0.111 0.104 0.100 0.127 0.207 0.101 *** p<0.01, ** p<0.05, * p<0.1 Notes: The price depreciation rate is the the predicted price from 4 months prior to the initial listing date minus the predicted price at the initial listing date. d1 is the excluded group. TOM is measured in weeks. Withdraw is a dummy variable equal to one if the listing is ultimately withdrawn. Regressions also include a Real Estate Owned dummy. Coefficients in bold denote cases where the difference in the coefficient relative to the coefficient in the decile immediately below is statistically significant at the 10 percent level. Standard errors clustered at the zip code level in parentheses. In specification 6, robust standard errors are reported.

Table 5: Parameter Estimates of the Structural Model Variable Description Estimate Std. error σ St. dev. of Initial Prior 0.0679 0.0054 σ St. dev. of buyer valuations 0.0841 0.0022 η σ St. dev. of buyer uncertainty over their valuation prior to inspection 0.0606 0.0016 v σ St. dev. of signal about weekly decline in mean valuations. 0.0322 0.0073 z σ St. dev. of Belief about weekly decline in mean valuations. 0.0094 0.0007 ε κ Buyer inspection cost. -0.0050 -c Weekly holding cost. 0.0000 -- γ Mean of Belief about weekly decline in mean valuations. -0.0033 -- 0 Note: The parameters without standard errors are fixed in estimation.

Table 6: Moments Used in Estimation Moment Simulated Moment 1 % of homes that sell 5 weeks after initial listing 4.30% 4.65% 2 % of homes that sell 10 weeks after initial listing 3.30% 3.89% 3 % of homes that sell 15 weeks after initial listing 2.20% 2.92% 4 % of homes that sell 20 weeks after initial listing 1.55% 2.23% 5 Median Time on Market 12 12 6 25th pctile of List Price - Sales Price 0.00% 0.00% 7 50th pctile of List Price - Sales Price 1.90% 2.86% 8 75th pctile of List Price - Sales Price 5.40% 5.42% 9 Corr(Change in List Price, Change in Predicted Price) 0.76 0.76 10 5th percentile of list price change in week 3 -4.40% -3.32% 11 Average Change in List Price -10.00% -12.23% 12 Median (List Price - Sales Price in Week 10 - (List Price - Sales Price in Week 5)) 0.95% 0.02% 13 Median (List Price - Sales Price in Week 15 - (List Price - Sales Price in Week 10)) 0.42% 0.13% 14 Stdev. of Monthly Price Changes 1.20% 0.67% Note: All prices are in logs. The changes in moments 9 and 11 are at the week of sale relative to the week of initial listing. In moment 14, the empirical moment is the standard deviation of monthly price changes in the Case-Shiller index for San Francisco and Los Angeles during my sample period. The model equivalent is the standard deviation of monthly average sales price changes.

Table 7: Sales Price Dynamics from the Simulated Model Dependent Variable Annual Price Semi- Semi-Annual Price Annual Price Change Annual Price Change Change Prices Aggregated Change Prices Aggregated OLS Estimates of AR(1) Coefficient -0.003 0.124 0.040 0.152 -0.013 0.279 0.079 0.346 Assumptions Uncertainty Over Changes in Market Conditions x x x x Average weekly sales prices are simulated for T=48,000 weeks and 20,000 new listings each week. Columns 2 and 4 show the results when average quarterly prices are used instead of average weekly prices. When there is no uncertainty over changes in market conditions, sellers beliefs at the time of listing are not sensitive to lagged market conditions, and any change in the distribution of buyer valuations during the listing period is perfectly observable.

Table 8: Volume and Time-on-Market Dynamics from the Simulated Model Dependent Variable Log(Sales Volume) Log(TOM) Quarterly Change in Price 0.000 6.732 0.000 -7.633 Assumptions Uncertainty Over Changes in Market Conditions x x Average weekly sales prices are simulated for T=48,000 weeks and 20,000 new listings each week. When there is no uncertainty over changes in market conditions, sellers beliefs at the time of listing are not sensitive to lagged market conditions, and any change in the distribution of buyer valuations during the listing period is perfectly observable.

Appendix Table 1: Robustness Specifications (1) (2) (3) (4) (5) Dependent Variable List Price TOM Withdraw Sales Price List Price Lagged Depreciation 0.6022*** 21.6028*** 0.7018*** 0.1370*** 0.7818*** (0.0482) (1.0780) (0.0315) (0.0247) (0.1185) Lagged Depreciation*Lagged Num. Sales ‐0.0018*** ‐0.0590*** 0.0002 0.0000 (0.0003) (0.0062) (0.0002) (0.0002) Lagged Num. Sales ‐0.0055*** ‐0.0000 ‐0.0001*** (0.0009) (0.0000) (0.0000) Change in Expected Price over Selling Horizon ‐0.5124*** (0.0096) Lagged Depreciation*Months Since Beginning of Sample Period ‐0.0187** (0.0078) Month fixed effects X X x x x Zip code fixed effects X Observations 171066 171066 171066 85603 172460 Adjusted R‐squared 0.111 0.096 0.202 0.100 0.112 Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1