Estimating the weight of opportunity costs in housing consumption

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3 Estmatng the weght of opportunty costs n housng consumpton Machel van Djk * CPB Netherlands Bureau for Economc Polcy Analyss P.O. Box GM The Hague The Netherlands *Correspondng author (mfvd@cpb.nl) Hghlghts Housng consumpton lends tself well for emprcally analyzng opportunty costs. I splt up the user costs of housng n out-of-pocket and opportunty costs. Homeowners wegh n ther opportunty costs at only 50 to 65 percent. It s unclear whether homeowners underestmate these costs or smply care less about them. Abstract People tend to neglect or underweght opportunty costs. Strong emprcal evdence for the sze of the underweghtng appears to be absent. What are the weghts people attach to opportunty costs relatve to out-of-pocket costs? In ths paper I estmate the weght of opportunty costs n probably the largest economc decson that households make: buyng a house. I show that homeowners attach approxmately twce as much weght to out-of-pocket costs of ther housng consumpton than to the opportunty costs assocated wth ths. Keywords: opportunty costs, out-of-pocket costs, housng JEL classfcaton: D11, D12, R21 3

4 1 Introducton Ratonal economc decson makng requres explct and mplct costs to be treated equvalently. Behavorsts 1, on the other hand, argue that people attach more weght to explct nformaton that s easly avalable, such as out-of-pocket expenses, and hardly consder the mplct costs of outsde optons when makng economc decsons. In order to understand actual economc behavor, knowng the weght that people attach to opportunty costs n real-lfe economc decsons s obvously key. Knowledge about the extent to whch people systematcally revew the outsde optons n economc decson-makng s essental not only for economc theorzng, but also for effectve economc polcy-makng. Unfortunately, the avalable behavoral research shows no clear consensus on ths matter. Some clam that human decson makers only underweght opportunty costs (see, e.g., Thaler, 1980). Others, such as Frederck et al. (2009), argue that people even neglect them entrely. Moreover, the results of most of these studes are based on expermental research n a merely laboratory-lke settng. Besdes consensus n expermental research, strong emprcal evdence based on real lfe emprcal data thus appears to be largely absent as well. Obvously, the lack of data on the actual sze of the opportunty costs lmts the scope for emprcal research. Yet, there s one form of consumpton that lends tself rather well to the emprcal analyss of the weght of opportunty costs. As many households fnance the purchase of ther homes by a mxture of mortgage loans and prvate equty, the costs of housng consumpton can well be dvded nto explct cash flows, notably nterest payments, and mplct opportunty costs of captal. Snce buyng a house s probably the largest economc decson that households make, analyzng the mpact of opportunty costs on housng consumpton may provde emprcal evdence to what extent opportunty costs are underweghted n sgnfcant, real-lfe economc decson-makng. Based on household-level data on Dutch homeowners, ths study ams to nvestgate the relevance of opportunty costs n housng consumpton relatve to the out-of-pocket expendtures related to housng. More precsely, the purpose here s to test the sgnfcance of the restrcton that opportunty costs and out-of-pocket costs have the same weght n a smple model of housng demand. The analyss clearly rejects ths hypothess and shows that Dutch homeowners attach approxmately twce as much weght to the out-of-pocket costs of ther housng consumpton than to the opportunty costs assocated wth ths. These fndngs mply that opportunty costs are ndeed sgnfcantly underweghted, but not completely neglected, n major, real-lfe economc decsons. 1 Ashraf et. al (2005) show that Adam Smth already drew attenton to the dstncton between out-of-pocket and opportunty costs.

5 2 Methodology 2.1 Theoretcal framework Housng consumpton lends tself well, but not exclusvely, to the emprcal analyss of the weght of mplct costs (see, e.g., Stango and Znman, 2009). Models of housng consumpton often make use of the so-called user cost approach (Poterba, 1984). The user cost approach elegantly sets out the annual cost of housng consumpton for an owner-occuper. User costs nclude mortgage nterest payments, mantenance and repar costs, property taxes, deprecaton and the opportunty costs of housng equty. By adoptng the user cost approach, housng costs can be rather easly dvded nto explct out-of-pocket costs and mplct opportunty costs. For most households, the user costs of ther housng consumpton wll be partly explct and partly mplct. Interest payments and taxes are obvously explct, whereas the opportunty costs of housng equty are much more mplct. Implct costs dffer from explct costs n two ways. Frst, mplct costs, such as the opportunty costs of housng equty, mght be perceved as foregone gans, whereas explct costs lke monthly nterest payments can be vewed as actual losses. As such, opportunty costs can be drectly lnked to prospect theory (Thaler, 1980). If the out-of-pocket costs of housng consumpton are ndeed vewed as losses and the opportunty costs of home equty are seen as foregone gans, prospect theory mples that the former wll be more heavly weghted by households n ther consumpton decson. In ths framework, households know the amount of opportunty costs, but smply attach less weght to them compared to out-ofpocket costs. A second dfference between mplct and explct costs of housng consumpton s related to ther salence. Opportunty costs are hardly observable, whle nterest payments can clearly be seen by households. Dfferences n salence mght therefore explan as well why opportunty costs of housng consumpton have less mental mpact than explct costs. But n ths case, households bascally underestmate the amount of opportunty costs rather than underweght them. Whether opportunty costs are underweghted or underestmated, both mechansms mply a larger role for explct costs. By adoptng the user costs approach of housng and dvdng user costs nto out-of-pocket costs and opportunty costs, t becomes possble to emprcally estmate f and to what extent opportunty costs are underweghted n housng consumpton. For ths, secton 2.2 wll provde a formal relatonshp between housng consumpton and user costs, whereas secton 2.3 presents the emprcal strategy for estmatng the relatve weght of opportunty costs. 5

6 2.2 Modellng housng consumpton The emprcal model that I estmate n secton 4 s based on a rather smple theoretcal model of housng demand. In ths model, the ndvdual demand functon for housng s derved from optmzng a Stone-Geary utlty functon subject to a gven budget constrant: max hx, 1 u h h x mn s.. t b wh p x x (2.1) Utlty s derved from housng consumpton h and other consumpton x. The specfcaton n (2.1) mples a unt elastcty of substtuton between (supra-mnmal) housng servces and other goods and servces. Housng consumpton h s measured n terms of housng servces,.e., the servces that each house yearly delvers to ts occupants. Ths noton s smlar to how Hall and Jorgenson (1967) treat the fxed assets of a frm, whch are assumed to supply captal servces to the frm tself. A standard house s assumed to delver one unt of housng servces. By further assumng that a standard house s equal to the average house n the sample, housng consumpton can be made comparable between households by calculatng the market value of ther houses relatve to the mean value of all houses. In model(2.1), h mn represents the mnmal housng consumpton. Total household ncome b s spent on housng servces at user costs w and other consumpton at prce p x. P x s set equal to 1 by assumpton. Parameter δ represents the housng preferences of households. The demand functon for housng servces that can be derved from model (2.1) s: h ( b wh ) w mn hmn (2.2) Demand for housng servces s partly fxed and depends for another part on dsposable ncome b and user costs w. It reproduces the stylzed fact that the expendture share of total housng consumpton typcally falls wth rsng ncome. Total dsposable household ncome b s the sum of ncome from labor, penson or other benefts and captal ncome. Household captal ncludes savngs and stocks, but also home equty, whch s defned as the dfference between the market value of the house and the mortgage loan. The user costs are equal to: wh s k p (2.3) 1 h

7 The varable s denotes the fscal subsdy rate of housng consumpton. Parameter ρ s equal to the real nterest rate plus a fxed rsk premum, and π s the expected steady state change n prce of the standardzed dwellng. The prce of a standard house s gven by p h, and k denotes the yearly costs of deprecaton and mantenance. Fnally, λ denotes the (annualzed) transacton costs. 2.3 Emprcal strategy For estmatng (2.2), I propose the followng emprcal model 2 : b ln h ln (1 ) f h e mn wpock, wopp, (2.4) The mnmal housng consumpton of household s equal to the mnmal housng consumpton h mn of a one person household multpled by an equvalence factor f. The equvalence factor depends on the sze and composton of the household, and ntends to correct for scale economes n housng consumpton. User costs w are dvded nto out-ofpocket costs w pock, and opportunty costs w opp,, such that w = w pock,+ w opp,. Out-of-pocket costs consst of the mortgage nterest payments mnus the net fscal subsdy for home owners. Implct costs are smply the remander of the user costs. They manly consst of the foregone gans of housng equty and the annualzed costs of deprecaton and mantenance. Although mantenance costs are obvously hghly explct and out-of-pocket from tme to tme, the defnton above assumes that wthn the user cost approach they are vewed as mplct when consdered on a monthly or annual bass. In order to nvestgate the relatve weght of mplct costs, I wll estmate a restrcted and an unrestrcted verson of model (2.4). In the restrcted model, β s set to 1. Ths restrcton mples that out-of-pocket costs and opportunty cost have the same weghts. The estmaton results of ths model wll gve us an dea to what extent our smple theoretcal model of housng consumpton n (2.2) s able to descrbe actual behavor n the Dutch housng market. In the unrestrcted model, β wll be estmated. If β turns out to be sgnfcantly dfferent from one, ths wll provde evdence that opportunty costs are weghted dfferently n housng consumpton. Model (2.4) can be estmated on the full sample of homeowners n the avalable database. However, that may well lead to endogenety n one of the regressors. Dsposable ncome b mostly conssts of ncome from labor, but home equty s also a source of dsposable (captal) ncome. Home equty s defned as the value of the house mnus the outstandng mortgage loan. Housng consumpton h s defned as the value of the house relatve to the value of the average owner-occuped house. An exogenous shock n house prces wll therefore affect 2 The logarthmc transformaton generates a hghly symmetrc dstrbuton of resduals. 7

8 both housng consumpton and home equty, provded that households do not mmedately adjust ther housng consumpton. As such, dsposable ncome s endogenous f we would estmate the model on the full avalable sample. However, the home equty of households that bought a home n the year of samplng s not affected by an exogenous change n the market value of ther newly bought property. For them, the equty nvested n ther home comes from savngs or from profts realzed from sellng ther prevous home. Ther ncome from home equty s therefore exogenous. To avod endogenety, I wll thus restrct the sample to households that bought a house n the year of samplng.

9 3 Data and descrptve statstcs The database WoON s a representatve cross-secton of about Dutch households. The database ams at provdng nformaton to polcymakers about the varous determnants of housng demand and lvng condtons n the Netherlands. Part of the data s admnstratve (partcularly household ncome), but most data are derved from questonnares sent out between September 2008 and May After selectng households that bought a home n the year of samplng and removng a small number of outlers, 1720 households reman. Below I wll explan all varables and parameters underlyng model (2.4). Housng consumpton h s the dependent varable based on the value of the house. The market value of the home n the database comes from an admnstratve source. The so called WOZ value of the house, upon whch several local taxes are based, s determned by the muncpalty n whch a house s located. But some of the explanatory varables also depend on the value of the house. As the market value s ultmately a stochastc varable, the error terms of the stochastc exogenous varables are most lkely correlated wth the error term of the dependent varable. I avod ths by takng the reported purchase prce of the house as the measure for housng consumpton. The purchase prce and the WOZ value are obvously hghly correlated, although n some cases large dfferences between the two exst. I excluded a lttle over 100 observatons where the WOZ value and the purchase prce dffer by more than 50%. Fnally, by multplyng purchase prces by I rescaled purchase prces n such a way that ther mean s equal to the mean of the WOZ values. Ths has no effect on the estmaton results, but t facltates the nterpretaton of the parameter estmates. The mnmal housng consumpton h mn of a household depends on ts sze and composton. Because of economes of scale, mnmal housng consumpton does not ncrease proportonally wth the number of persons. To correct for ths, I use the equvalence factor f as used by Statstcs Netherlands. It s based on the followng formula: f A 0.8C (3.1) A s the number of adults and C s the number of chldren. If I smply use the number of persons for the sze of a household n the regresson, ths sgnfcantly affects the parameter estmates for h mn and δ, but t has no sgnfcant effect on the estmated value of β. As mentoned earler, dsposable ncome b s the sum of ncome from labor, penson or other benefts and captal ncome. Household captal ncludes savngs and stocks, but also home equty, whch s defned as the dfference between the market value of the house and the mortgage loan. The nomnal captal ncome rate s mputed and set at 4% of the value of 3 The collecton of data and the survey s repeated every three years. WoON 2012 was delvered n 2013 and was not yet accessble whle the analyses n ths paper were beng carred out. 9

10 total captal. 4 Ths ncome s taxed at a flat rate of 30%. In the Netherlands, home equty s exempted from captal taxaton, but I account for ths fscal subsdy n the calculaton of the net user costs of housng. All varables used n the calculaton of dsposable ncome are from admnstratve sources, except for the value of the mortgage. To correct for outlers, I have removed a small number of households that report a mortgage loan larger than 150% of the value of ther home. Parameter ρ n (2.3) s set at 5% for all households. I assume a real nterest rate of 2% and a rsk premum of 3%. The expected real change n the prce of a standardzed dwellng π s assumed to be 1%. Ths s consstent wth a long term economc growth rate of 1.7% per year combned wth a long term supply elastcty of Yearly costs of deprecaton and mantenance k are assumed to be equal to 1.5%. The (annualzed) transacton costs λ are set at 0.25%. Fnally, the prce of a standard house s equal to 295 thousand euro. In the absence of fscal subsdy, the user costs of a standard house would then be equal to 16.9 thousand euro, 5.75% of the value of a house. 5 Ths rate s very close to the long run relaton between prces and rents found by Ambrose et al. (2013) for houses n Amsterdam from 1650 through The net user cost of a standard house,.e. the prce for one unt of housng consumpton, s 12 thousand euro. The average fscal subsdy rate of housng consumpton n the sample s hence almost 7 thousand euro, or 29 percent of the gross user costs. Ths farly hgh subsdy s due to the low taxaton of mputed rent on the one hand (less than 1% of the value of the house) and the full deductblty of mortgage nterest on the other. On top of that, home equty s exempted from captal ncome taxaton. I calculated the fscal subsdy for each household usng ther actual nterest mortgage payments, the market value of ther homes and ther mortgage loans. I further use a unform tax rate of 47% 6 for calculatng the fscal advantage due to nterest deductblty and an effectve tax rate of 1.2% of home equty for calculatng the fscal benefts of ts fscal exempton. As mentoned n 2.3, out-of-pocket costs w pock consst of the mortgage nterest payments mnus the net fscal subsdy for home owners. 7 Most Dutch households pay ther nterest on a monthly bass, and also the fscal subsdy s usually (provsonally) pad out each month. I therefore subtract the subsdy from the out-of-pocket expenses. Implct costs w opp are smply the remander of the user costs. To calculate the out-of-pocket and opportunty costs per unt of consumpton, I smply dvde these costs by the level of consumpton h. Because some respondents report unrealstcally hgh nterest payments, I remove a small number of 4 Settng ths rate a 3% or 5% has only a very small effect on the estmaton results below. 5 Increasng or decreasng gross user costs by 1%-pont agan has only a very small effect on the estmaton results. 6 At ths rate the total fscal subsdes n the database match the macro-economc data on fscal subsdes n By excludng mantenance from out-of-pocket cost, I run the rsk of underestmatng these. The database I use contans some (categorzed) nformaton on the costs of mantenance and rebuldng carred out n the year prevous to the survey. However, t s unknown whether these were pad n cash or fnanced by a loan. In the Netherlands, t s common practce though to fnance larger constructon jobs by a mortgage loan, partcularly at the tme when people buy another home. In general, nterest on these loans s tax deductble, whch makes these loans relatvely attractve. Therefore, I expect a mnor effect of gnorng out-of-pocket mantenance costs. As an ndrect robustness check, I ran the regressons n the next secton separately for the group of households wth low (<2500 euro) and hgh (2500 euro and hgher) reported mantenance cost. I found no sgnfcant dfferences n any of the estmated demand parameters.

11 households wth mpled mortgage nterest rates larger than 10%. Table 3.1 shows some descrptve statstcs of the varables I use n estmatng model (2.4). Table 3.1 Descrptve statstcs Varable Mean Medan Standarddevaton Mnmum Maxmum Housng consumpton (h) Equvalence factor (f) x 1000 euro Dsposable ncome (b) Out-of-pocket user cost per unt of housng consumpton (w pock ) Opportunty cost per unt of housng consumpton (w opp ) The sample contans 1720 observatons of households that bought a home n the year of samplng. Despte removng some outlers n advance, we stll observe some extreme values for notably the opportunty costs. Ths s due to households reportng mortgage nterest rates close to 10% n combnaton wth large mortgage loans. In some cases, ths leads to out-of-pockets costs larger than the users costs (and hence, by my defnton, to negatve opportunty costs). On average, out-of-pocket costs are close to 7000 euro s per unt of housng consumpton and opportunty costs a lttle over 5000 euro s. These varables show a substantal amount of varaton across the sample. Ths dsperson arses because of dfferences n the loan to value rato and n dfferences n the actual nterest payments. Dfferences between mean and medan values are rather small. 11

12 4 Results and dscusson 4.1 Estmaton results The analyss shows that opportunty costs are substantally underweghted n the Dutch housng market. Dutch homeowners attach approxmately twce as much weght to the outof-pocket costs of ther housng consumpton compared to the opportunty costs assocated wth ths. Table 4.1 shows the results from estmatng model (2.4) by means of ordnary least squares. In the unrestrcted model, β s estmated at A Wald-test on the hypothess that β = 1 shows that ths hypothess should be rejected. Furthermore, the unrestrcted model produces a much better result than the model wth the restrcton β =1 accordng to a standard F-test. Despte ts smplcty, the restrcted model performs rather well n explanng the housng consumpton of Dutch homeowners. Yet, the observed varaton n housng consumpton s much better explaned by allowng the weght of opportunty costs to be dfferent from the weght of out-of-pocket costs. Apparently, households are led much more by out-of-pocket costs than by the true economc costs of ther housng consumpton. Table 4.1 Estmaton results model (2.4) Model h mn δ β R-squared adjusted Model wth restrcton β = (0.01) Unrestrcted model 0.23 (0.01) 0.11 (0.01) 0.11 (0.01) 0.49 (0.02) Note: standard errors n parentheses. All estmated parameters dffer sgnfcantly from 0 at less than 1% sgnfcance level. 4.2 Alternatve explanatons Despte the strong statstcal evdence regardng the weght of opportunty costs n estmatng model (2.4), we cannot be sure that the underweghtng of opportunty costs s the sole drver of the regresson results. A number of alternatves mght explan these results as well. Frst, the estmated low weght n model (2.4) can be the result of an ncorrect specfcaton of the model. Ignorng credt constrants s one way to obtan a falsely low estmaton of the weght of opportunty costs. The low weght of opportunty costs mples that households wth prvate equty spend a larger share of ther total dsposable ncome on housng consumpton than households that are fully dependent on mortgage credt. Stll, ths pattern could also be the result of credt ratonng. Credt ratoned households wll not be able to optmze ther housng consumpton. But households wth suffcent equty wll be able to compensate the restrcton on ther optmal housng consumpton by usng ther

13 prvate funds to fnance ther homes. Second, gnorng the age of household members mght also dstort the estmaton results. Perhaps the optmal housng consumpton s drectly related to age. For nstance, the desre to have a (larger) garden may ncrease wth age, at least up to a certan pont. Snce age and equty are correlated, the postve relatonshp between equty and the share of housng costs n dsposable ncome mght just be explaned by age-dependent preferences. Thrd, housng preferences can drectly depend on home equty as well, for nstance through habt formaton. An exogenous rse n house prces mght affect the desred levels of housng consumpton of ncumbent homeowners buyng a new house. Incumbent Dutch households that bought a home n 2008 have most lkely obtaned a substantal proft on sellng ther prevous home. In the Netherlands, real house prces have ncreased almost contnuously snce the md-80s. Under the assumpton of habt formaton, these households wll spend a larger share of ther (captal) ncome on housng consumpton. They got used to lvng n a house n a hgher prce range and are smply not wllng to lower ther housng consumpton n accordance wth ther ntal preferences. Fourth, wthn a cross-secton of households a postve relatonshp between equty and housng consumpton could also make sense from a lfe-cycle perspectve. If ageng households dssave from captal they bult up earler n lfe, a larger share of ther dsposable ncome can be spent on consumpton, ncludng housng. Fnally, mental accountng may explan why more equty s assocated wth a hgher share of housng costs n dsposable ncome. Shefrn and Thaler (1998) argue that the margnal propensty to consume out of current ncome, current wealth and future ncome s dfferent. The share of housng expendtures n ncome from captal may then be sgnfcantly dfferent from ts share n e.g. labor ncome. By addng a number of explanatory varables to model (2.4), I am to test whether these alternatve explanatons falsfy my results. I have added age class dummes, the loan-toncome rato and a dummy varable for ncumbency. I have also splt up captal ncome nto ncome from housng equty and from other prvate funds. Obvously, the cross-sectonal nature of my data lmts the scope for properly testng the alternatve explanatons, partcularly the one related to the lfe-cycle perspectve. The analyses below should therefore be seen as a frst robustness check of my man emprcal results. For testng the alternatve explanatons, I frst extend the base model by decomposng dsposable ncome b. Frst, ncome out of labor, penson or welfare s denoted by b w. Imputed captal ncome from savngs and other fnancal assets s labeled b s. Fnally, mputed ncome from home s denoted by b h. Our emprcal model then becomes: ln h ln (1 ) f h b b b e w, s, h, mn wpock, w opp, (4.1) 13

14 By addng parameter α, I ntroduce another mechansm through whch hgher home equty could lead to hgher housng consumpton. If the margnal propensty to consume from b h s hgher than the propensty to consume from b w, more home equty wll lead to a relatvely hgher housng consumpton as well. In that case, t s not related to a lower weght of opportunty costs, but merely due to dfferent consumpton patterns. As a robustness check of the results n the prevous secton, the ncluson of parameter α s therefore relevant. Opportunty costs and ncome from home equty mght, however, be hghly correlated. Both are drectly related to how much households nvest of ther own captal nto ther houses. However, opportunty costs have an addtonal source of emprcal varaton. For a gven level of home equty, out-of-pocket costs may dffer because n practce households pay dfferent mortgage nterest rates. Snce opportunty costs are the complement of out-ofpocket costs, we can observe some varaton n opportunty costs that s not related to the amount of home equty. In fact, the sample correlaton coeffcent between w opp and b h s equal to 0.5. Table 4.2 below presents the results of estmatng the varous models I dscuss n ths secton. The results from estmatng model (4.1) show that α s sgnfcantly larger than one and the estmated value of β goes up, though t stll remans sgnfcantly less than one. At frst glance, allowng for dfferences n the propensty to consume from the varous sources of ncome seems approprate. Yet t does not reject the hypothess that opportunty costs are sgnfcantly underweghted. For testng whether credt constrants affect my results, I estmate the followng model: ln h ln (1 ) f h b b LTI b e w, s, h, mn wpock, w opp, (4.2) As I have no data on actual credt constrants, I approxmate these by the loan to ncome rato (LTI). Households wth a low LTI were most lkely less credt constraned than households wth hgh LTI. If credt constrants explan why more equty s assocated wth hgher housng consumpton, we would expect that household wth a hgh LTI spend a larger part of ther ncome from home equty on housng consumpton. In terms of model (4.2), we would expect that under the hypothess of credt ratonng, α s equal or close to one and γ s sgnfcantly postve. As the thrd column n Table 4.2 shows, the ncluson of the loan-to-ncome rato n model (4.2) hardly affects the value of β or any of the other estmates. Credt constrants apparently do not affect the man results from secton 4.1. To test whether age affects my man results, I classfy households nto three age groups, accordng to the age of the prncpal household member: young (<30 years), mddle-aged (between 30 and 60) and old (>60). These age classes are denoted by three dummy

15 varables, respectvely D y, D m and D o. The model then becomes: 3D m + 4 Do bw, bs, bh, ln h ln (1 ) f h D + D e mn 1 m 2 o wpock, wopp, (4.3) From the fourth column n Table 4.2 we can conclude that the ncluson of the age dummes also does not affect the man results. The role of habt formaton can approxmately be evaluated by ncludng a dummy varable D own that equals one f the household prevous resdence was owner-occuped as well. If ψ 1 n model (4.4) turns out to be sgnfcantly postve, ncumbent homeowners exhbt a hgher mnmal consumpton level than new homeowners. A sgnfcantly postve estmate for ψ 2 wll suggest a hgher propensty to consume from home equty for ncumbent homeowners. bw, bs, 2 Down, b h, ln h ln (1 ) f h D e mn 1 own, wpock, wopp, (4.4) If we compare he results from estmatng model (4.4) wth the other models n Table 4.2, we see that t s actually the ownershp of the prevous home that explans why a hgher share of own fundng s assocated wth hgher supra-mnmal housng consumpton rather than dfferences n the propensty to consume from the varous sources of ncome. In fact, the parameter estmate for α s not sgnfcantly dfferent from 1 n model (4.4). Ths may suggest that habt formaton has ndeed played a role for Dutch households. Nevertheless, ths fndng stll does not reject the hypothess of underweghtng of opportunty costs n housng consumpton. Fnally, to nvestgate whether mental accountng makes a dfference n the emprcal results, I allow the propensty to consume from ncome derved from savngs and fnancal assets to be dfferent from the other ncome sources as well. Ths leads to the followng model: ln h ln (1 ) f h b b b e w, s, h, mn wpock, w opp, (4.5) As the last column n Table 4.2 shows, the parameter estmate for θ n model (4.5) s not sgnfcantly dfferent from 1. Mental accountng, albet hghly ndrectly approxmated, thus does not seem to affect my man emprcal results from secton 4.1 as well. In concluson, the data clearly support the hypothess that opportunty costs are substantally underweghted. Our emprcal analyss of housng consumpton confrms the fndngs of expermental research by Thaler (1980). Stll, I do not fnd evdence for a complete neglect of opportunty costs, such as n Frederck et al. (2009). By and large, opportunty costs only wegh n for about 50 to 65 percent of ther actual value n the reallfe economc act of buyng a home. 15

16 Table 4.2 Estmaton results alternatve models Model (2.4) (4.1) (4.2) (4.3) (4.4) (4.5) Mnmal housng consumpton h mn 0.23** 0.25** 0.25** 0.28** 0.24** 0.25** (0.01) (0.01) (0.01) (0.02) (0.01) (0.01) Housng consumpton propensty δ 0.11** 0.11** 0.11** 0.08** 0.10** 0.11** (0.01) (0.01) (0.01) (0.01) (0.01) (0.01) Weght of opportunty costs β 0.49** 0.62** 0.63** 0.62** 0.63** 0.62** (0.02) (0.03) (0.03) (0.03) (0.03) (0.03) Housng consumpton from home equty α 3.43** 3.60** 3.27** 1.09* 3.41** (0.35) (0.45) (0.37) (0.48) (0.36) Impact of LTI on consumpton from home equty γ Effect of mddle-aged on mnmal consumpton λ * (0.02) Effect of old-aged on mnmal consumpton λ (0.05) Effect of mddle-aged on supra-mnmal consumpton λ ** (0.01) Effect of old-aged on supra-mnmal consumpton λ (0.01) Effect of ncumbency on mnmal consumpton ψ ** (0.01) Effect of ncumbency on supra-mnmal consumpton ψ ** (0.55) Housng consumpton from other captal ncome θ 1.24** (0.28) Adjusted R Note: standard errors n parentheses observatons were used n all models. * estmated parameters dffer sgnfcantly from 0 at less than 5% sgnfcance level. ** estmated parameters dffer sgnfcantly from 0 at less than 1% sgnfcance level.

17 5 Conclusons Human decson makers attach less weght to opportunty costs, but they do not fully gnore them. When people buy houses, the foregone revenues of the prvate equty they nvest only wegh n for about 50 to 65 percent of ther actual value. Expermental research hghlghted ths phenomenon before, but I show that also n major, real lfe economc decson makng the underweghtng of opportunty costs s ndeed sgnfcant. In practce, people apparently do not obey the normatve mplcatons of standard economc theory, whch tells us that outpocket costs and opportunty costs should be treated equally. Although opportunty costs are relevant n vrtually every economc decson, often t s not easy to know exactly what they are. I have argued that housng consumpton offers the opportunty to analyze the weght of opportunty costs. Another area to explore ths knd of research mght be the car market. Do people who fnance ther car wthout a loan underweght the opportunty costs of nvestng ther own money as well? And do we see a dfference n the consumpton of cars between old and new ones? New cars normally have low out-of-pocket user costs, but hgh mplct costs because of sgnfcant deprecaton. For older cars, t s usually the opposte: hgh out-of-pocket mantenance costs versus low deprecaton. Correctng for qualty, does ths dfference between old and new cars bas the demand for cars towards new ones? The actual cause of the underweghtng of opportunty costs provdes another research opportunty. Is t related to loss averson, where out-of-pocket costs have larger mental mpact than foregone revenues on equty? Or can underweghtng be attrbuted to the lack of salence of opportunty costs? In case of the former, polcy mplcatons are vrtually absent. The underweghtng s then merely due to prospect-theoretc preferences. But f t s a matter of underestmatng the true economc costs, perhaps better nformaton on the opportunty costs when people buy a home could help people make better decsons. Hoskn (1983) has shown that explct nformaton on opportunty costs can ndeed make a dfference to the economc decson that people make. Explct nformaton on the opportunty costs of housng consumpton even can have some postve effects on macro-economc stablty. In a housng market boom, ncumbent homeowners see ther home equty grow. When they move to another home, ther hgher equty suppresses out-of-pocket costs and pushes demand for propertes even further f households ndeed underestmate the true user costs of ther new homes. A better awareness of the actual user costs of housng consumpton may then, to some extent obvously, decrease the rsk of a self-renforcng prcng bubble on the housng market. Many governments feel the need to warn households for the hgh costs of borrowng, but t mght also make sense to tell people that usng ther own resources comes at a prce as well. I certanty acknowledge the practcal dffcultes of mplementng such a polcy, yet t may elmnate the potentally unwanted bas resultng from underestmatng actual housng costs. 17

18 References Ambrose, B. W., Echholtz, P. and Lndenthal, T., House Prces and Fundamentals: 355 Years of Evdence. Journal of Money, Credt and Bankng, 45 (2/3), Ashraf, N., Camerer, C., and Loewensten, G., Adam Smth, Behavoral Economst. Journal of Economc Perspectves 19 (3), Frederck, S., Novemsky, N., Wang, J., Dhar, R., and Nowls, S., Opportunty cost neglect. Journal of Consumer Research 36 (4), Hall, R. and Jorgenson, D., Tax Polcy and Investment Behavor. Amercan Economc Revew 57 (3), Hoskn, R., Opportunty Cost and Behavor. Journal of Accountng Research 21(1), Poterba, J., Tax Subsdes to Owner-Occuped Housng: An Asset-Market Approach. Quarterly Journal of Economcs 99 (4), Shefrn, H. and Thaler, R., The behavoral lfe-cycle hypothess, Economc Inqury, 26 (4), Stango, V. and Znman, J., What Do Consumers Really Pay on Ther Checkng and Credt Card Accounts? Explct, Implct,and Avodable Costs. Amercan Economc Revew 99 (2), Papers and Proceedngs of the One Hundred Twenty-Frst Meetng of the Amercan Economc Assocaton, Thaler, R., Towards a postve theory of consumer choce. Journal of Economc Behavor and Organzaton 1,

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