People Respond To Incentives : The following example has been taken from Freakonomics
Lets say you want to sell your house and for that you hire a real-estate agent. She sizes up its charm, takes some pictures, writes a brilliant advertisement, shows the house to prospective buyers and negotiates. She’s getting a nice cut for all this work. On the sale of $300,000 house, a typical 6% yields $18,000 as commission. That’s a lot but you know you couldn’t have done it on your own so you cough up the money. The real estate agent is an expert in her field. She knows the housing market, the value of the house and even the buyer’s frame of mind. Many such experts have made themselves indispensable. Doctors, lawyers, contractors, stockbrokers, auto mechanics, financial brokers: they all enjoy a gigantic informational advantage. And they use that advantage to help you, the person who hired them, get exactly what you want for the best price. Right? It would be lovely to think so. But experts are human, and humans respond to incentives. When a real-estate agent sells her own house she tries to get the best deal. Presumably this is also your incentive when you are selling your home. And so your incentive and the real-estate agent’s incentive would seem to be nicely aligned. Her commission after all, is based on the sale price. But as incentives go, commissions are tricky. First of all, a 6% real estate commission is typically split between the seller’s agent and the buyer’s agent. Each agent then kicks back half of her take to the agency. Which means that only 1.5% of the purchase price goes directly in your agent’s pocket.
So on the sale of $300,000 house, her personal take would be $4,500. But what if the house was actually worth more than $300,000. What if with a little more effort and a few more ads, she could have sold it for $320,000. After paying of the commission of 6% that puts an additional $18,800 in your pocket. But the agent’s additional share – her personal 1.5% of the extra $20,000 is a mere $300. If you earn $18,800 she earns only $300, may be your incentives aren’t aligned after all. Is the agent willing to put out all that extra energy, time and expense for just $300?