Explaining Price Rigidities on the Housing Market with Prospect Theory

A puzzling observation on housing markets is the strong positive correlation between prices and trade volume for rising prices. Yet, in a declining market suppliers hesitate to adjust prices to a smaller demand. The majority of literature addresses this issue using search and matching models. A behavioral approach as it is very common in the economic finance literature has only been considered briefly to explain price rigidities. This work provides a theoretical model in order to better understand incentives on the supply and demand side of the housing market.From a behavioral finance perspective and in particular the prospect theory, utility is determined by changes in wealth rather than absolute values. Prospect theory further suggests different attitudes towards risk for potential losses and potential profits. Thus, the price setting mechanism is influenced by a certain reference point, e. g. the originally paid price or the house's construction costs. Therefore, the market development dictates whether home owners accept purchase offers easily or are reluctant to sell. In particular, if the market faces a downturn and the market value of an object falls below the originally paid nominal price, sellers will be less averse towards risk. On the other hand, sellers might accept prices below the market value but above the originally paid price if the market developed favorably.The most pressing question is how prices are determined on the housing market. Following finance literature, the price evolution can be thought of as a stochastic process, i.e. a Brownian motion. This would suffice to explain different attitudes towards risk for homogeneous agents. However, according to the underlying value function in prospect theory, the buyer would not be willing to buy a house at market price for sheer investment purposes, since it is too risky. Therefore, in my model, the personal assessment of a houses value consists of two components: the investment value and the personal housing value.My model especially applies for the market for single-family homes, since this type of accommodation is typically owner occupied and makes up a large part of the housing stock in rural areas. Not only does the model help understand why households might be reluctant to sell even if the current housing situation is suboptimal in regard to e. g. household size. It does also suggest a higher ratio of vacant houses for markets which took a downturn.