Prospect Theory, Reverse Disposition Effect and the Housing Market

We model a house seller’s pricing decision under a prospect value function. Our model shows that reference dependence generates a disposition effect, which is magnified by loss aversion. Surprisingly, diminishing sensitivity will lead to a local reverse disposition effect in which a seller’s asking price can be decreasing with increasing potential loss. Our model also predicts a larger price dispersion in a cold market and reaffirms the price-volume relation. We find consistent evidence using multiple listing service data in Virginia. Finally, the empirical pricing curve suggests the extent of diminishing sensitivity can vary with the loss/gain position of the agent.