The unintended consequences of regulations : a case study of the Estate Agents Ordinance in Hong Kong

Abstract

It is well known that transaction cost is high in the second-hand housing market. Due to the heterogeneous nature of housing and market participants, buyers and sellers are facing high information cost. Therefore, real estate agents are hired to facilitate transactions. Real estate agents are typically rewarded based on successful transactions rather than the quality of information they provide, which results in a principal-agent problem. This problem is even more serious in the case of dual agency in Hong Kong’s property market. Instead of maximizing the interests of their clients, real estate agents may act unethically to maximize their own gain at the expense of their clients’ benefits. To protect the buyers and sellers from real estate agents’ unethical behavior in Hong Kong, the Estate Agents Ordinance (EAO) was enacted in 1997. This study examines the unintended consequences of this ordinance.

EAO aims to protect the consumers’ interest in property transaction. One of its measures is to prohibit the real estate agents from taking part in the transaction they served without letting their clients know about it. Under EAO, real estate agents cannot buy from a seller who mistakenly offered a below market price (due to high information cost) without letting the seller know that he/she is the buyer (commonly known as “Rat Trading” in Hong Kong). In a “Rat Trading”, real estate agents will quickly resell the unit bought from their clients and profit from the price difference. The resale of the unit at market price will supersede the earlier underpriced transaction price information. Before 1994, the underpriced transaction may not even be recorded in the Land Registry if the real estate agent can re-sell the unit before the legal title is transferred to him. In this unethical trading, the real estate agents help to “discover” and disseminate the more “correct” price information, although unintentionally.

After the enactment of the EAO, “Rating Trading” virtually disappeared. When a seller mistakenly offered a below market price, the real estate agents may not provide price information to correct the mistake as they have no obligation to do so. Instead, they will quickly find a buyer so that they can earn the commission from the transaction. Therefore, the unit is likely to be transacted at the price offered by the seller, which introduces noise to the market and thereby lowers the quality of price information. There are two testable hypotheses arising from this. First, price dispersion increases after the enactment of the EAO. Second, the increase in price dispersion is asymmetric with a longer tail to the right. Empirical findings confirmed these hypotheses.

Confirmation of these two hypotheses gives several policy implications. First, EAO failed to protect the consumers. Uninformed sellers are still selling their property at below market prices. Even worse, EAO gives an unintended consequence of introducing more market noise to the housing market. This increases the transaction cost of consumers in pricing the housing unit. Finally, the sale of the underpriced unit in a very short period of time means that it may not be sold to the highest bidder. This entails some forms of rent dissipation and thus welfare loss.