Game Theory

By Jack Newcombe

May 29, 2015 4 min read

Imagine that you are a criminal.

You do not work alone. You have a partner in crime.

Now imagine that the police catch you and your partner.

They split the two of you up, so that you are in separate rooms. The police enter your room and start questioning you about the crime. At this point, you have two choices: You can rat out your partner or you can say nothing.

In this situation, the first question you should ask yourself isn't, should I talk or not? It's, is my partner going to talk?

There are four potential outcomes. The first outcome would be if you talk and your partner said nothing. The police will appreciate your cooperation and have evidence against your partner. The second and less favorable outcome would be the reverse of that; you stay silent while your partner sings. The other two outcomes are more nuanced. If you both talk, you both cooperated (good) but you both have testimony against yourself (bad). If you both stay silent, the cops have nothing and you will both go free.

The scenario described is known as the prisoner's dilemma and is a commonly used example of game theory. Game theory is an economic principle that examines how individuals should act relative to other parties in situations involving decisions of conflict or cooperation.

Game theory is ubiquitous in everyday life, but it is especially present throughout the process of buying or selling a home.

Let's begin with deciding what price to list your house. Usually, your real estate agent will take a look at comparable homes in the area (comps), calculate a price per square foot, multiply that number by the size of your house and hang a "for sale" sign. That is a great place to start, but it ignores a very important question: How will potential buyers react to the price?

Pricing high might make buyers think that the house is more valuable than it is. They might think that linoleum is hardwood and tile is the new granite. On the other hand, pricing too high might (and probably will) turn people away. When this happens, the house will sit on the market and become stale. The longer a house sits on the market, the less cache it has, and the sellers can appear desperate.

Pricing too low might result in a seller leaving money on the table. A good strategy is to find the market price of the house based on the comps and price a hair under that. It entices interested buyers with the hopes of creating a bidding war.

Now let's go to the buyer's side of the table. You find a house you love and want to make an offer, but at what price? You could come in at full ask (or even above ask), but you might overpay. It can be stressful. There is no magic elixir for this other than to have a good, honest, trustworthy agent who can represent you and let them do the negotiating.

Let's say that a seller priced the house perfectly and four people make offers. Now the seller goes to all four parties and says, we have four offers, make your best and final offer. This is obviously an amazing position to be in for the sellers and only happens when the stars align: great market, great location, great house and well-priced.

If you're one of the bidders, do you go all in with your highest number or do you think you can get the house for less? It depends on what you think the other parties are going to bid.

Again, there is no right answer here, and the best you can do is have that awesome real estate agent do his/her best to get as much information on the other offers as possible. After that, it comes down to how much you want the property.

At some point, you might have to pay a premium for a home just like you might have rat out your partner to the police, but only if you think they are ratting you out or if someone is going to try and outbid you.

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