NOBEL LAUREATE DANIEL KAHNEMAN explains how a firm’s pricing decisions have implications for the fairness perception in the minds of its customers. AND WHY firms have to be very careful with these decisions.
In customer market, it is acceptable for a firm to raise prices (or cut wages) when profits are threatened and to maintain prices when costs diminish. It is unfair to exploit shifts in demand by raising prices or cutting wages. Just as it is often useful to neglect friction in elementary mechanics, there may be good reasons to assume that firms seek their maximal profit as if they were subject only to legal and budgetary constraints. However, the patterns of sluggish or incomplete adjustment often observed in markets suggest that some additional constraints are operative. Several authors have used a notion of fairness to explain why many employers do not cut wages during periods of high unemployment (George Akerlof, 1979; Robert Solow, 1980). Arthur Okun (1981) went further in arguing that fairness also alters the outcomes in what he called customer markets characterised by suppliers who are perceived as making their own pricing decisions, have some monopoly power (if only because search is costly), and often have repeat business with their clientele.
Okun explained these observations by the hostile reaction of customers to price increases that are not justified by increased costs and are therefore viewed as unfair. He also noted that customers appear willing to accept “fair” price increases even when demand is slack The argument used by these authors to account for apparent deviations from the simple model of a profit-maximizing firm is that fair behavior is instrumental to the maximisation of long-run profits. In Okun’s model, customers who suspect that a supplier treats them unfairly are likely to start searching for alternatives; Akerlof (1980, 1982) suggested that firms invest in their reputation to produce goodwill among their customers and high morale among their employees; and trusted suppliers may be able to operate in markets otherwise devastated by the lemons problem (Akerlof, 1970; Kenneth Arrow, 1973). In these approaches, the rules of fairness define the terms of an enforceable implicit contract: Firms that behave unfairly are punished in the long run.
A more radical assumption is that some firms apply fair policies even in situations that preclude enforcement – this is the view of the lay public. If considerations of fairness do restrict the actions of profit-seeking firms, economic models might be enriched by a more detailed analysis of this constraint. Specifically, the rules that govern public perceptions of fairness should identify situations in which some firms will fail to exploit apparent opportunities to increase their profits. Following are four propositions about the effects of fairness considerations on the behavior of firms in customer markets.
PROPOSITION 1: When excess demand in a customer market is unaccompanied by increases in suppliers’ costs, the market will fail to clear in the short run. Evidence supporting this proposition was described by Phillip Cagan (1979), who concluded from a review of the behavior of prices that, “Empirical studies have long found that short-run shifts in demand have small and often insignificant effects [on prices]”. Other consistent evidence comes from studies of disasters, where prices are often maintained at their reference levels, although supplies are short (Douglas Dacy and Howard Kunreuther, 1969). A particularly well-documented illustration of the behaviour predicted in proposition 1 is provided by Alan Olmstead and Paul Rhode (1985). During the spring and summer of 1920, there was a severe gasoline shortage in the US West Coast where Standard Oil of California (SOCal) was the dominant supplier. There were no government-imposed price controls, nor was there any threat of such controls; yet SOCal reacted by imposing allocation and rationing schemes while maintaining prices. Prices were actually higher in the East in the absence of any shortage. Significantly, Olmstead and Rhode note that the eastern firms had to purchase crude at higher prices while SOCal, being vertically integrated, had no such excuse for raising price. They conclude from confidential SOCal documents that SOCal officers “...were clearly concerned with their public image and tried to maintain the appearance of being ‘fair”’.
In customer market, it is acceptable for a firm to raise prices (or cut wages) when profits are threatened and to maintain prices when costs diminish. It is unfair to exploit shifts in demand by raising prices or cutting wages. Just as it is often useful to neglect friction in elementary mechanics, there may be good reasons to assume that firms seek their maximal profit as if they were subject only to legal and budgetary constraints. However, the patterns of sluggish or incomplete adjustment often observed in markets suggest that some additional constraints are operative. Several authors have used a notion of fairness to explain why many employers do not cut wages during periods of high unemployment (George Akerlof, 1979; Robert Solow, 1980). Arthur Okun (1981) went further in arguing that fairness also alters the outcomes in what he called customer markets characterised by suppliers who are perceived as making their own pricing decisions, have some monopoly power (if only because search is costly), and often have repeat business with their clientele.
Okun explained these observations by the hostile reaction of customers to price increases that are not justified by increased costs and are therefore viewed as unfair. He also noted that customers appear willing to accept “fair” price increases even when demand is slack The argument used by these authors to account for apparent deviations from the simple model of a profit-maximizing firm is that fair behavior is instrumental to the maximisation of long-run profits. In Okun’s model, customers who suspect that a supplier treats them unfairly are likely to start searching for alternatives; Akerlof (1980, 1982) suggested that firms invest in their reputation to produce goodwill among their customers and high morale among their employees; and trusted suppliers may be able to operate in markets otherwise devastated by the lemons problem (Akerlof, 1970; Kenneth Arrow, 1973). In these approaches, the rules of fairness define the terms of an enforceable implicit contract: Firms that behave unfairly are punished in the long run.
A more radical assumption is that some firms apply fair policies even in situations that preclude enforcement – this is the view of the lay public. If considerations of fairness do restrict the actions of profit-seeking firms, economic models might be enriched by a more detailed analysis of this constraint. Specifically, the rules that govern public perceptions of fairness should identify situations in which some firms will fail to exploit apparent opportunities to increase their profits. Following are four propositions about the effects of fairness considerations on the behavior of firms in customer markets.
PROPOSITION 1: When excess demand in a customer market is unaccompanied by increases in suppliers’ costs, the market will fail to clear in the short run. Evidence supporting this proposition was described by Phillip Cagan (1979), who concluded from a review of the behavior of prices that, “Empirical studies have long found that short-run shifts in demand have small and often insignificant effects [on prices]”. Other consistent evidence comes from studies of disasters, where prices are often maintained at their reference levels, although supplies are short (Douglas Dacy and Howard Kunreuther, 1969). A particularly well-documented illustration of the behaviour predicted in proposition 1 is provided by Alan Olmstead and Paul Rhode (1985). During the spring and summer of 1920, there was a severe gasoline shortage in the US West Coast where Standard Oil of California (SOCal) was the dominant supplier. There were no government-imposed price controls, nor was there any threat of such controls; yet SOCal reacted by imposing allocation and rationing schemes while maintaining prices. Prices were actually higher in the East in the absence of any shortage. Significantly, Olmstead and Rhode note that the eastern firms had to purchase crude at higher prices while SOCal, being vertically integrated, had no such excuse for raising price. They conclude from confidential SOCal documents that SOCal officers “...were clearly concerned with their public image and tried to maintain the appearance of being ‘fair”’.
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