Price formation and the appraisal function in real estate markets

A real estate market model characterized by incomplete information, costly search, and varying expectations is presented. The model describes a self-selection process for market participants and a distribution of transaction prices. These transaction prices, which arise from a Nash equilibrium, can be expressed as a noisy signal, reflecting incomplete information as well as the conditions of sale. The appraiser's role is formalized as the task of signal extraction. The model emphasizes the differences in information available to individual buyers and sellers, who make transactions only infrequently, and the appraiser, whose expertise comes from observing many transactions. Based on the model, it is shown that contrary to popular perceptions, appraisal smoothing is consistent with an optimal updating strategy.