Are fairness constraints on profit-seeking important?

ELSEVIER

Journal of Economic Psychology 16 (1995) 73-96

Are fairness constraints on profit-seeking important? Robert Piron a, Luis Fernandez b,. a Economics Department, Oberlin College, Rice Hall 233, 10 North Professor Street, Oberlin, OH 44074-1095, USA b SBER, Room 995, National Science Foundation, 4201 Wilson Boulevard, Arlington, VA 22230, USA

Received 4 February 1994; accepted 18 October 1994

Abstract

We report the results of two experiments designed to probe the extent to which consumers will retaliate against firms that engage in "unfair" business practices. The first experiment presents hypothetical scenarios similar to those used by Kahneman et al. (1986b), but where retaliation against an unfair firm is costly. The second experiment simulated one of these scenarios and gave subjects the opportunity to retaliate "for real". Results indicate a moderately large loss in customer base due to unfairness.

I. Introduction

In standard economic theory, every decision-maker is usually assumed to maximize a utility function that is "selfish". By "selfish" we mean that this utility function depends only on variables that measure the decision-maker's "direct" welfare: the consumer's consumption vector, the firm's profit stream, the political candidate's probability of being elected, etc. Although a utility function can, in principle, have the welfare of other decision-makers

* Corresponding author. E-mail: [email protected]; Fax: + 1 703 306-0485. 0167-4870/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved SSDI 0167-4870(94)00037-9

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1~ Piron, L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

as one of its arguments, economists usually avoid using such "non-selfish" preference relations. The assumption that preferences are selfish is not innocuous. It places important constraints on the behavior of decision-makers. This strong assumption need not be exactly true to be useful, though. As long as non-selfish concerns have a low enough weight in the utility functions of most decision-makers in most situations, such concerns can be ignored without causing any serious degradation in the predictive accuracy of the economic model. For example, suppose a consumer knows that the level of her purchases will have an effect on the price of the product, albeit small. If her purchase decisions are governed by selfish preferences, this price effect is so small that it makes sense to model her as a price-taker. This may no longer be true, though, if the welfare of other consumers also carries a large weight in her purchase decisions. Although her purchase decision has a very small effect on each of these other consumers, the aggregate effect may no longer be negligible. If the aggregate effect of her actions has a non-negligible weight in her utility function, then this consumer can probably no longer be modeled successfully as a price-taker. Likewise, it is standard to assume each consumer's purchase decision is selfish in the sense that the consumer ignores the effect of her decision on the profits of the firm selling the good or service. This implies that consumer purchase decisions should depend only on the price charged by the firm and the firm's competitors, and not on the firm's costs, the compensation of its workers and owners, or the prices it charges for other unrelated goods and services. Furthermore, it is generally assumed that a firm does not worry about whether the exercise of any market power it may have will alter the d e m a n d for its products. This assumption, however, may not hold if consumers' purchase decisions are based not only on relative prices but also on the perceived "fairness" of the firm's pricing actions. We will say that a firm faces a "fairness constraint" if the d e m a n d for the firm's product depends in part on consumers' perceptions of the firm's normative behavior. Operationally, the firm faces a fairness constraint if there are actions, such as raising its prices when a competitor goes out of business, which cause consumers to reduce their purchases by more than one would expect from price effects alone. There exists an interesting literature on fairness and output markets, with the following articles serving as a good introduction to the subject: Frey and P o m m e r e h n e (1993), a survey study of the perceived fairness of

R. Piron, L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

75

price rises due to excess demand; Oliver and Swan (1989), where satisfaction with dealers was found to be an important determinant of fairness perceptions by customers; Sashkin and Williams (1990), an examination of the relationship between fairness perceptions of retail store managers and non-supervisory employees with regard to their firm and the cost structure of those firms; Kachelmeier et al. (1991a,b), studies of the effect on output prices of fairness perceptions of customers as a test of the theory of dual entitlements, i.e. the "acquisition utility" derived from ordinary microeconomic theory and the "transaction utility" generated by fairness perceptions of consumers; Deng et al. (1992), an experimental study of fairness and posted offer markets; Hoffman et al. (1995), in which the players in an ultimatum bargaining game can retaliate by unilaterally quiting the game. Nowhere in this literature, however, do we find any investigation of the question which mosts interests us: can the "transaction disutility" derived from dealing with unfair firms be sufficient to cause significant customer defection and, therefore, constitute an important constraint on profit-seeking? In seeking an answer to this question, our paper becomes an extension of the seminal survey research conducted by Kahneman et al. (1986a) (hereafter denoted by KKT), who found evidence of "non-selfish" consumer preferences involving fairness perceptions in a wide range of hypothetical scenarios (KKT, 1986b). Soliciting answers to questions concerning the fairness of profit-making by firms through a telephone survey, KKT found the general contours of "community standards of fairness for the setting of prices and wages". Specifically, they found that in so-called "customer markets" and labor markets, respondents thought that firms which raise prices or cut wages in the face of threats to profitability were behaving "fairly" or "acceptably". It was also thought by respondents that not reducing prices in the face of cost reductions was also fair/acceptable. However, respondents generally thought that firms raising prices a n d / o r cutting wages in the face of increasing d e m a n d for their goods or an increasing supply of workers were behaving "unfairly". KKT then go on to discuss the influence of consumers' perceptions of fairness on firms by making certain market predictions, such as: price reductions will usually take the form of discounts, price changes will be more highly correlated with costs than with demand, markets will tend not to clear in the presence of rising d e m a n d (unless the firm's costs go up at the same time), and monopolists will charge well below the profit-maximizing price. Although KKT's survey results provide evidence of a "fairness" con-

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IL 15"ron,L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

straint, their survey does not reveal whether this constraint is important. Fairness constraints will be important in determining the firm's pricing decisions only if consumers punish firms that charge "unfair prices" by reducing significantly their purchases of the firms' products or services even when it is costly for them to do so. The reason is simple. Suppose consumers punish unfair firms only when the cost of doing so is low. The cost of retaliation will be low only when there exists a large supply of close substitutes. But if there are close substitutes to the firm's goods and services, then the constraints on pricing due to standard market competition will be much stronger than that due to fairness and the latter will have little, if any, impact. Fairness considerations are potentially important to the firm precisely when the cost of retaliation by consumers is high; i.e., when there are no nearby competitors to the firm or there are no close substitutes for the good or service the firm is selling. If even moderate retaliation costs are sufficient to discourage the consumer from reducing her patronage, then the firm (as well as the economic analyst) can essentially ignore fairness considerations when analyzing consumer and firm behavior. Unfortunately, the KKT survey provides no information on the willingness of consumers to retaliate against unfair firms when doing so is costly. In this paper we report the results of two experiments designed to probe the extent to which consumers will actually retaliate against firms that engage in "unfair" business practices. In the first experiment subjects were asked to judge the behavior of firms in six KKT-like market scenarios. Subjects who judged a firm's action as "unfair" or "very unfair" were then asked to choose from a m e n u of retaliatory measures. These ranged from doing nothing, to complete and immediate cessation of all business dealings with the firm. The scenarios were constructed so that the most effective forms of retaliation against the firm would also be the most costly for the respondent to pursue. By design, the extent of the firm's unfairness and the cost of retaliating against the firm were randomly varied across the respondents. This experimental design allowed us to measure the sensitivity of the respondents' actions to both the firm's behavior and to the opportunity cost of retaliating against the firm by ceasing to buy from it. The second experiment simulated one of the KKT scenarios, that of an apple seller who raises his prices when the wholesale price of apples goes up even though he has a large inventory of apples. Subjects were asked to judge the fairness of the firm's action and then given the opportunity to retaliate against the firm by buying from a competing firm.

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77

2. Experiment 1: Hypothetical retaliation

2.1. Method Subjects

An experiment was conducted on a random sample of Oberlin students, faculty and administrative staff in the Spring of 1991. Subjects were selected from the Oberlin College phone directory by choosing every fourth name. 191 people responded of which 144 provided usable surveys. Of these 99 or 69% were students, 27 or 19% were faculty, and 18 or 12% were administrative staff. A m o n g the students 43% were m e n and the mean age was 20; among faculty, 70% were men and the mean age was 44; and among staff, 40% were m e n and the mean age was 58.

Questionnaire The subjects were asked to judge six business dealings that were patterned after those in KKT. (See the Appendix.) Five scenarios involved the firm's price and one involved the compensation of the firm's workers. A typical scenario is: A local hardware store located conveniently for your shopping has been selling snow shovels for $15. The morning after a large snow storm, the store raises the price to $25. You need a snow shovel to clear your driveway, etc., and the nearest store with snow shovels in stock is 10 minutes travel time away and is charging $20 for them. The next closest store is so far away that it is irrelevant to your decision. Those subjects who labeled a firm's actions as either "unfair" or "very unfair" were then asked to choose responses from among five different types of retaliation. Two responses were weak: (a) "Continue doing business with the first firm" or (b) "Continue doing business locally from the first firm but complain about the price increase to the proper person". Three responses were strong: (a) "Buy one more time locally from the first firm but do business with the second firm in the future," (b) " D o business immediately with the second firm," or (c) " D o without the product or service involved." The experimental manipulations consisted of the firm's price(wage) before the change, the distance to the nearest alternative supplier, and the price charged by the closest alternative supplier. We have highlighted these

78

R. Piron, L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

\\ uoile!leleJou

~-.

/4

j!etuN~., j /

'~ x

~aeA

~ \ ~

, J!Nun

Alele.lopo~

J!e,tul3

Fig. 1. Hypothesized decision process of subjects in Experiment 1.

manipulations in the sample scenario shown above by underlining them. Our use of such manipulations is a significant advance over the survey method used by KKT in which every respondent was presented with exactly the same scenarios. 2.2. Theoretical model In measuring the sensitivity of retaliation to cost, we have made a number of assumptions about the decision-making process used by our respondents. First, we have assumed that our respondents' answers are the outcome of the three-step sequential decision-tree shown in Fig. 1. That is, we assume our respondents: (1) first decide whether the action is "fair" or "unfair"; (2) if the action is judged to be "fair," no retaliation is taken against the firm; (3) if the action is judged to be "unfair", then the respondent decides whether the action is "very" unfair or not; (4) finally, based on the perceived degree of unfairness of the firm's action the respondent decides how to respond. The first judgment about the fairness of the firm's action is assumed to depend on the respondent's personal characteristics and the type of action taken by the firm (e.g., the size of the firm's price increase or wage cut). Since not all of the variables that enter into this judgment are observable, the decision is not completely predictable. Let Po equal the probability that respondent i judges the firm's action in scenario j as "unfair". The ratio P i J ( 1 - Pi~) is the odds that respondent i will judge the action taken by the firm in scenario j as unfair rather than fair. We assume that the

R. Piron, L. Fernandez~Journal of Economic Psychology 16 (1995) 73-96

79

log-odds ratio is a linear function of the severity of the firm's action and the observable characteristics of the decision-maker. Specifically, we have In 1 Pu - P u = a ° j + ° t l j A C T i j q- a2TYPEi + a 3 S E X i + ot4LOGAGE i + a s L O G I N C i + a6TYPE i × SEX~ + a7TYPE i × LOGINC~,

(1)

where A C T u is the percentage price increase or wage cut taken by the firm in the j t h scenario presented to respondent i, T Y P E / i s a dummy variable for whether respondent i was a student rather than a faculty or college staff m e m b e r (1 = faculty or staff), SEX i is a gender dummy (1 = " m a l e " , 2 = "female"), L O G A G E i is the logarithm of respondent i's age, L O G I N C i is the logarithm of respondent i's total family income, and the a's are unknown parameters to be estimated. Two interaction effects (TYPE x SEX and T Y P E x LOGINC) were added to account for the different behavior of students and non-students. Each slope coefficient is approximately equal to the percentage change in the odds per unit change in the variable which it multiplies. We have allowed the first two coefficients, a 0 and al, to differ across scenarios, but assumed that the other slope coefficients are the same across scenarios. We have included demographic characteristics in (1) in order to determine whether they are not only statistically, but also e c o n o m i c a l l y , significant. This information is important since a firm faces a fairness constraint only if the particular type of customer who buys its product or service is likely to retaliate against "unfair" actions by the firm. Similarly, knowledge of the significance and magnitude of the demographic coeffcients allows us to predict the markets in which firms face a fairness constraint. For example, if women are much less likely to retaliate than m e n (as would be revealed by a large negative and statistically significant coefficient for SEX), then firms that sell primarily to women (e.g., cosmetics) will pay much more attention to fairness than will firms that sell primarily to m e n (e.g., beer). Once a respondent has decided the firm's action is "unfair", she then decides whether the action is only moderately unfair or "very unfair". Again, we assume this decision depends on the respondent's personal characteristics and the action taken by the firm. Let p V denote the

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R. Piron, L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

probability that respondent i judges the firm's action in scenario j to be "very unfair" given that the respondent believes it to be unfair. We assume p

.V

In - - ,s = flos + f l l s A C T i s 1 - P.V

+

fl2TYPEi -t- fl3SEXi

tJ

+ fl4LOGAGEi + flsLOGINCi q- fl6TYPEi × SEXi + fl7TYPEi × LOGINCi.

(2)

As was the case with (1), the slope coefficients in (2) measure the percentage change in the odds per unit change in the variable that they multiply. Finally, after deciding whether the action is "very unfair" or not, the respondent decides whether to retaliate against the firm and how. We assume this decision depends upon the respondent's personal characteristics, the respondent's assessment of the degree of unfairness of the firm's action, and the cost of retaliation. Letting Pi R denote the probability that respondent i will retaliate against the firm in scenario j, given that he or she has judged the firm's action as unfair, we assume In--

= Yos + Y ~ T Y P E i + y2SEXi + y3LOGAGEi + ~/4LOGINCi

+ ysTYPEi × LOGINCi + "Y6VERYUFq + "Y7DISTij + ysALTPRis,

(3)

where VERYUFis is a dummy variable that equals 1 if respondent i feels the firm's action in scenario j is "very unfair", DISTis is the distance of respondent i to the second nearest firm in scenario j, and ALTPRis is the price charged by the second nearest firm in scenario j faced by respondent i. ALTPR can be thought of as incorporating the value of all the amenities and disamenities offered by the second store relative to the first store. Hence, ALTPR would be positive if the stores' prices were the same, but the "unfair" store had more non-price amenities than the next nearest store. We make the following predictions: Hypothesis 1. The unfairness of a firm's actions is an increasing function of

its price increase (wage decrease), implying als > 0 and /31s.> 0, for j = 1 , . . . , 6.

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81

Table 1 Logit estimates of Eq. (1) (Is the firm " f a i r " ? ) Variable

Symbol

Coefficient estimate

Standard error

Significance probability

CONSTANT DUMMY 2 DUMMY 3 DUMMY 4 DUMMY 5 DUMMY 6 ACT × DUMMY 1 ACT × DUMMY 2 ACT × DUMMY 3 ACT X DUMMY 4 ACT × DUMMY 5 ACT × DUMMY 6 TYPE SEX LOGAGE LOGINC TYPE × SEX TYPE × LOGINC

a01

- 12.40991

2.8881 2.4523 1.5206 1.5155 1.7526 1.5252 0.0629 0.3325 0.05686 0.0578 0.0672 0.0146 1.7389 0.2274 0.7643 0.1518 0.3953 0.4603

0.001 < 0.669 0.085 0.193 0.953 0.399 0.016 0.165 0.163 0.294 0.004 0.034 0.878 0.163 0.001 < 0.045 0.023 0.109

a02 ~t03 a04 a05 a06 all c~12 al3 al4 a15 a16 a2 a3 c~4 c~5 a6 a7

a01 ct01 a01 c~01 c~01

Measures of fit: Likelihood ratio =

1.04727 2.61708 1.97266 0.10353 1.28731 0.15167 0.46192 0.08182 0.06056 0.19213 0.03090 - 0.26694 0.31712 3.32692 - 0.30412 0.89929 - 0.73834

108.0. The significance probability with 17 df is less than 1%.

Correctly predicted = 69.8%.

Hypothesis 2. The likelihood of retaliation is an increasing function of the perceived unfairness of the firm's action, implying 3'6 > 0. Hypothesis 3. The likelihood of retaliation is a decreasing function of the cost of doing so, implying 3'7 < 0 and 3'8 < 0. 2.3. Parameter estimates Maximumlikelihood estimates (MLE) of the coefficients in Eqs. (1)-(3) are reported in Tables 1-3. The signs of all coefficients are as predicted. Certain of these coefficients have particular economic interest. In Eqs. (1) and (2), the coefficients O/lj and /31: are, respectively, the elasticities of the odds of judging the firm's action as "unfair" (rather than "fair") and "very unfair" (rather than "moderately unfair") with respect to the firm's price increase or wage cut in scenario j. These elasticities, which are collected together in Table 4, are all positive, thereby confirming Hypothesis 1. But, they are also all small in magnitude, which implies that the size of the firm's price increase

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Table 2 Logit estimates of Eq. (2) (Is the firm "very unfair"?) Variable

Symbol

Coefficient estimate

Standard error

Significance probability

CONSTANT DUMMY 2 DUMMY 3 DUMMY 4 DUMMY 5 DUMMY 6 ACT×DUMMY 1 ACT×DUMMY 2 ACT x DUMMY 3 ACT × DUMMY 4 ACTX DUMMY 5 ACT × DUMMY 6 TYPE SEX LOGAGE LOGINC T Y P E × SEX TYPE × LOGINC

/3ol /3o2 - / 3 o l

- 6.60817 -3.98500 - 0.91557 -2.00895 - 4.57185 - 3.62584 0.00893 0.57350 - 0.03762 0.10221 0.19493 0.04151 -- 0.81008 0.31089 1.09651 0.58220 2.47463 - 1.02755

4.7430 2.7852 2.0496 2.1525 2.4267 2.4420 0.0801 0.3676 0.0973 0.1032 0.0832 0.0328 2.8287 0.3033 1.2664 0.2215 0.7548 0.6836

0.164 0.152 0.655 0.351 0.060 0,138 0.911 0.119 0.699 0.322 0.019 0.205 0.775 0.305 0.387 0.009 0.001 0.133

/303 -/3ol /3o4 -/301 /305 -/301

/3o6 -/3Ol /311 /312 fl13 /314 /315 /316 /32 /33 /34 /35 /36 /37

Measures o f fit: Likelihood ratio = 68.0. T h e significance probability with 14 df is less than 1%. Correctly predicted = 73%.

Table 3 Logit estimates of Eq. (3) (Strongly retaliate?) Variable

Symbol

Coefficient estimate

Standard error

Significance probability

CONSTANT DUMMY 2

Yol To2 - Yol

DUMMY 3

Yo3 - Yol

DUMMY 4 DUMMY 5 DUMMY 6 TYPE SEX LOGAGE LOGINC TYPE x LOGINC VERYUF DIST ALTPR

To4 - To1 To5 - YOl 3'o6 - 3'ox 3'1 Y2 3"3 Y4 3'5 T6 Y7 Ys

- 2.09407 - 1.3009 0.08849 - 0.33884 0,26822 - 0,51887 1.0265 0.20076 1.69274 - 0.50923 - 0.8182 1.41228 - 0.05504 0.03698

3.5718 0.4194 0.4638 0.5104 0.4555 0.4956 2.3358 0.2615 1.0918 0.2140 0.6800 0.2883 0.0173 0.0152

0.558 0,002 0.849 0,507 0,556 0.295 0.660 0.443 0.121 0.017 0.229 0.001 < 0.001 0.015

-

Measures o f fit: Likelihood ratio = 68.2. The significance probability with 13 df is less than 1%. Correctly predicted = 73%.

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83

Table 4 The elasticity of the odds of judging the finn's action as "unfair" rather than "fair" (alj) and as "very unfair" rather than "moderately unfair" (/31j) with respect to the firm's price increase or wage cut Scenario j

alj

fllt

1

0.152 (0.063) 0.462 (0.333) 0.082 (0.059) 0.061 (0.059) 0.192 (0.067) 0.031 (0.015)

0.00893 (0.0801) 0.573 (0.368) - 0.0376 (0.097) 0.102 (0.103) 0.194 (0.832) 0.0416 (0.0328)

2 3 4 5 6

Note: Numbers in parentheses are estimated standard errors.

or wage reduction is relatively important in determining how the firm is judged. Table 3 confirms Hyptheses 2 and 3. Strong retaliation against the firm is greatly affected by both the respondent's perception of the severity of the firm's action (VERYUF) and the cost of retaliating (DIST and ALTPR). The estimated coefficient for V E R Y U F is 1.41, implying that the odds of retaliating are over four times greater if the firm's action is viewed as "very unfair" than if it is not so viewed. The estimated coefficient for DIST is -0.055, meaning that every additional minute of travel time to the nearest competing store reduces the odds of retaliating by 5.5%. Hence, a 10 minute travel time to the nearest competing store reduces the odds of strong retaliation by 55%. The estimated coefficient for ALTPR is -0.037, meaning that every additional $1 price differential between the unfair store and the nearest competing store reduces the odds of retaliating by 3.7%. So, a $13 price differential reduces the odds of retaliating by almost 50%. Since a 10 minute travel time and a $13 price differential represent relatively large competitive advantages, in many cases retaliation is probably not important enough to alter the firm's behavior. The ultimate consideration to a firm is the proportion of its customers who will strongly retaliate, which we will denote as Pr{retaliate}. The reported retaliation rates among our respondents are reported in Table 5. The last line shows the proportion of all respondents who reported they both considered the firm's behavior "unfair" and would strongly retaliate

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IL Piron, L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

Table 5 Survey results Response

Fair Unfair

Scenario 1

2

3

4

5

6

26.3% 73.7%

21.7% 78.3%

41.5% 58.5%

59.9% 40.1%

30.5% 69.5%

62.4% 37.6%

5.0% 25.0% 30.0%

14.9% 43.2% 58.1%

17.1% 20.7% 37.8%

22.7% 34.7% 57.3%

21.4% 34.1% 55.6%

54.4% 13.2% 67.6%

35.7% 5.7% 28.6% 70.0%

13.5% 17.6% 10.8% 41.9%

9.9% 40.5% 11.7% 62.2%

1.3% 9.3% 32.0% 42.7%

10.3% 34.1% N/A 44.4%

1.5% 30.9% N/A 32.4%

51.6%

32.8%

36.4%

17.1%

30.9%

12.2%

Retaliation among respondents who feel the action is "unfair" Weak retaliation A B A+B Strong retaliation C D E C+ D+ E

Strong retaliation among all respondents

Note: Many respondents responded with multiple actions - e.g., complain to the manager and stop shopping at the store. In such cases, we assigned to the respondent the strongest of the responses marked or written-in. 10 respondents gave answers that could not be matched with any of the pre-chosen responses.

against the firm for this behavior. Although between 35% and 80% of our respondents judged the firm's actions to be unfair, the fraction who stated they would actually "strongly retaliate" was much lower, ranging from 12% (scenario 6) to 52% (scenario 1). Fewer than 20% of our respondents said they would strongly retaliate against the firm in scenarios 4 and 6, in which the firm raises its prices in the wake of a temporary reduction in the supply of a good. Between 30% and 40% said they would strongly retaliate in scenarios 2, 3, and 5, in which the firm is taking advantage of long-term market power either to cut wages or increase prices. And over 50% said they would strongly retaliate in scenario 1, in which a hardware store increases the price of snow shovels immediately after a large snowstorm. Although suggestive of the importance of fairness issues to consumers, Table 5 does not control for the characteristics of the respondent. Let Pr{unfair} denote the proportion of its customers who will judge its actions as unfair; let Pr{very unfairlunfair} denote the proportion of those customers who feel its actions are unfair who also feel its actions are "very" unfair; let Pr{retaliatelvery unfair} denote the proportion who will strongly

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85

Table 6 Probability that an average respondent judges firm's action as "unfair" Scenario

Faculty/staff Male Female Student Male Female

1

2

3

4

5

6

Average

7.8% 22.2%

84.2% 94.7%

36.5% 66.0%

19.6% 45.1%

12.3% 32,0%

8.4% 23.5%

28.1% 47.2%

40.6% 48.4%

97.7% 98.3%

82.3% 86.4%

66.3% 73.0%

53.1% 60.8%

42.4% 50.3%

63.7% 69.5%

Note: Characteristics of the "average" respondent: A g e = 30 and Income=S40,000. Percentage price(wage) change of firm = 10%.

retaliate among those who feel its action is very unfair; and let Pr{retaliate[moderately unfair} denote the proportion who will strongly retaliate among those who feel its action is moderately unfair. Then the calculus of conditional probabilities yields the formula: Pr{retaliate} = Pr{retaliatelunfair} × Pr{unfair} (4) where Pr{retaliatelunfair} = Pr{retaliatelvery unfair} x Pr{very unfair [unfair} + Pr{retaliate[moderately unfair} x Pr{moderately unfair [unfair}. Table 6 reports the probability of judging the firm's action as unfair for an "average" respondent (30 years old with a family income of $40,000) disaggregated by the respondent's sex, type (student or faculty/staff), and scenario. Table 7 reports the probability of retaliation for the same "average respondent" when the next closest firm is 21 minutes away and is Table 7 Probability that an average respondent will both judge the firm's action as unfair and strongly retaliate against it Scenario 1

Faculty/staff Male Female Student Male Female

5

Average

2

3

4

6

1.4% 8.0%

7.4% 17.8%

6.5% 18.5%

2.5% 10.2%

2.5% 8.3%

0.8% 3,1%

3.5% 11.0%

26.2% 34.2%

47.2% 53.6%

48.4% 55,8%

33.3% 41.3%

31.9% 39.6%

17.2% 22.9%

34.0% 41.2%

Note: Characteristics of the "average" respondent: A g e = 30 and Family Income = $40,000. Percentage price(wage) change of firm = 10%. Distance to second store = 21 minutes. Price premium paid at other store = 20%.

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R. Piron, L. Fernandez/Journal of Economic Psychology 16 (1995) 73-96

Table 8 Elasticity of the probability of retaliation with respect to the respondent's age Scenario

Faculty/staff Male Female Student Male Female

6

Average

4.28

4.57

3.91

3.57

4.07

3.14

2.02

2.25

2.94

2.03

1.69

1.91

2.59

1.74

1

2

3

4

5

4.53

2.34

3.53

4.19

3.78

1.62

2.47

3.30

2.64

1.01

1.32

2.27

0.87

1.09

Note: Characteristics of the "average" respondent: price(wage) change of firm store = 2 0 % .

= 10%.

Age = 30

Distance to second store

and Family Income = 21 m i n u t e s . P r i c e

= $40,000. Percentage premium paid at other

charging 20% more than the offending local firm. Generally, women are more likely than men and students are more likely than faculty or staff to judge the firm's action as unfair. Among those who thought the action was unfair, male faculty and staff are the least likely to retaliate and students are three to four more times more likely to retaliate than the faculty - even after we adjust for their differing ages! With the exception of female students, the probabilities are all under 50% and for male faculty and staff, they are under 7%. Tables 8 and 9 report the estimated elasticity of the odds of retaliating with respect to the respondent's age and income, respectively. Two results are striking. First, the probability of retaliation by an "average respondent" who faces "average retaliation costs" increases with age and declines with income. Since income is a proxy for the time cost of travelling to another

Table 9 Elasticity of the probability of retaliation with respect to the average respondent's income Scenario 1

Faculty/staff Male Female Student Male Female

2

3

4

5

6

Average

- 2.05

- 1.46

- 1.75

- 2.01

- 1.98

- 2.15

- 1.90

- 1.67

- 1.15

- 1.32

- 1.62

- 1.69

- 1.96

- 1.57

- 0.28

- 0.19

- 0.22

- 0.28

- 0.33

- 0.46

- 0.29

-0.24

-0.17

-0.18

-0.23

-0.28

-0.41

-0.25

Note: Characteristics of the "average" respondent: price(wage) change of firm store = 2 0 % .

= 10%.

and Family Income = $ 4 0 , 0 0 0 . Percentage Distance to second store = 21 minutes. Price premium paid at other Age = 30

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store, the latter implies that the substitution effect dominates the income effect. Second, all the elasticities are greater than one and are as large as 4.61 with the exception of the income elasticity of students. We strongly suspect that the latter is due to severe errors-in-variable bias caused by the use of family income (as reported by the student) as a proxy for the student's income. These very high elasticities imply that the rate of retaliation is sensitive to the demographic makeup of a firm's customers. 2.4. Discussion The overall implication of our first experiment is that whether a firm faces an important "fairness constraint" depends strongly on who its customers are, moderately on the cost to the consumer of ceasing to do business with the firm, and weakly on the size of the firm's action. Some opportunistic business practices were generally tolerated by our respondents in the sense that although they might disapprove, they would not retaliate against the firm unless the costs of doing so were very small. A limitation of this experiment is that the retaliation is necessarily hypothetical. It is impossible to know whether those who claimed they would retaliate would ever actually do so in "real" situations where real money and time were at stake. In order to explore the extent to which retaliation threats are credible, we used one of our scenarios (scenario 4) as the basis for a second experiment.

3. Experiment 2: Actual retaliation 3.1. Method Subjects

The experimental subjects were the 57 students in two introductory economics classes at Oberlin College in the Spring of 1992. We will refer to each class as Group 1 and Group 2. Procedures and stimulus materials The subjects were told that they would participate in "an experiment in decision-making". Every subject ("buyer") in the two classes was given an initial endowment of 50 coupons, each of which was worth "50 cents". Buyers were informed: (1) they could use this endowment to purchase

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apples over the next few weeks, (2) unspent coupons would be converted to cash at the end of the experiment, and (3) the exchange rate between "coupon dollars" and real dollars would not be revealed until after the experiment was over but would be high enough to ensure that they were paid something for participating in the experiment. At the beginning of each class period, the buyers were given the choice of purchasing one apple for $1.50 from a paid research assistant (the "vendor") who came to the classroom or purchasing an apple for $2.00 at a house ("off-campus store") located four blocks (about a ten minute walk) from the classroom. For two weeks (four class periods) the prices were kept the same. During this time, the vendor and the buyers became familiar with each other as they would in any customer market. However in the fifth class period, the vendor informed the buyers that: the wholesale price of apples had risen; both he and the off-campus store had several weeks supply of apples in inventory; he was raising the price of his apples immediately to $2.50 while the off-campus store would continue to charge $2.00 per apple. After the buyers made their fifth purchase decision, they were given a questionnaire that asked them to rate the vendor's price increase as either: "completely fair," "acceptable, . . . . unfair," or "very unfair". Those who judged the price increase as "unfair" or "very unfair" were then asked to state how they intended to respond to the price increase. The choices were the same as those used in the questionnaire we used in Experiment 1 reported above: (A) Continue to buy from the vendor. (B) Continue to buy from the vendor but complain about the price increase. (C) Buy one more time from the vendor, but buy at the other (off-campus) store in the future. (D) Buy apples from the other store. (E) Other. Please explain. Finally, at the following (sixth) session the buyers were allowed to purchase apples one more time. The prices charged by the vendor and the off-campus store remained the same ($2.50 and $2.00 respectively). The buyers were n o t told this would be their last purchase. This sixth purchase allowed us to see whether or not the buyers who claimed in session 5 that they would retaliate against the unfair vendor "next time" would actually carry out their threat. It also allowed us to see whether buyers who retaliated against the vendor the first time would continue to do so.

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At the end of the sixth session, all buyers were given a second ("exit") survey in which they were asked to state where they had bought their apples during sessions 5 and 6 (since the vendor's price increase). Those who reported they had bought at the off-campus store in either period were asked to state their reasons for doing so. Their choices were: (1) You believed that the classroom vendor acted unfairly by raising his price. Hence, you no longer wanted to support his business, regardless of the price. (2) You wanted to save money, since the price of apples at the off-campus store was lower than the new and higher price of the classroom vendor. (3) Other. Please explain. Those who reported that they did not buy from either the vendor or the off-campus store were also asked to explain their actions. Their choices were: (1') You did not want to continue supporting the classroom vendor because you felt he acted unfairly in raising his price, so you chose not to buy an apple from anyone. (2') You planned on buying an apple from the off-campus store because you thought the classroom vendor acted unfairly by raising his price, but simply forgot to do so. (3') You planned on buying an apple from the off-campus store even though you thought the classroom vendor had acted fairly, but simply forgot to do so. (4') Other. Please explain. Once the buyers had completed the exit survey, they were informed that the experiment was over. They were then asked to state what they thought the experiment had been about. Not one person gave an answer that was even remotely correct. Only then was the true purpose of the experiment revealed to the participants. 3.2. Results

The results of Experiment 2 are reported in Tables 10-12. Table 10 reports the buyer's judgements about the vendor's price increase, while Table 11 reports their threatened and actual responses. Fifty-six percent of all buyers judged the vendor's action as either "unfair" or "very unfair". All of these buyers threatened some form of retaliation: 47% threatened immediate retaliation and 53% threatened future retaliation. Every buyer who threatened to retaliate immediately did so and 73% continued to

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Table 10 Judgement of price increase by vendor Group

Number of subjects "Completely fair" or "Acceptable" "Unfair" or "Very unfair"

1

2

Both

31 48% 52%

26 38% 62%

57 44% 56%

retaliate the following period. Sixty-three percent of those subjects who threatened to retaliate in the future period retaliated in the next session. Table 12 reports the results of the exit survey that was designed to distinguish true "retaliators" from "bargain hunters". 3.3. Discussion Experiment 1 altered the original KKT survey instrument in an important way: we explicitly specified the "cost of retaliation" in every scenario. Doing so allowed us to measure the power of the KKT hypothesis. To fully test the KKT hypothesis, however, our survey of intentions was followed by a second experiment that induced realizations. On the evidence of our modified KKT-style survey and experiment, it seems there is evidence that fairness constraints are, or should be, important to firms. Our results indicate moderately large customer defection in the face of perceived unfair behavior by firms. In our experiments, after adjusting for ordinary demand effects, the residual customer defection due to "moral offense" amounted to about a quarter of the total customer base.

Table 11 Reaction to price rise by vendor Group

Judged action as unfair Threatened immediate retaliation Immediately retaliated Also retaliated at next session Threatened future retaliation Retaliated at next session Threatened no or weak retaliation

1

2

Both

16 50% 100% 63% 50% 63% 0%

16 44% 100% 86% 56% 44% 0%

32 47% 100% 73% 53% 53% 0%

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Table 12 Reasons for buying from off-campus store Group 1

2

Both

Bought from off-campus store on day 5 because vendor was unfair because of price difference and thought vendor fair because of price difference but thought vendor unfair

16 44% 50% 6%

11 64% 36% 0%

27 52% 44% 4%

Bought from off-campus store on day 6 because vendor was unfair because of price difference and thought vendor fair because of price difference but thought vendor unfair

19 47% 47% 6%

14 71% 29% 0%

33 58% 39% 3%

It should be remembered at this point that our subject-customers were spending from an experimenter-provided "money" endowment. This feature of our design could be construed as implying (as a referee suggested) that "real" costs were not being incurred. We disagree. Since the endowment was given without constraint, the subjects could well have simply added this "windfall" to their net worth. Some sacrificed all or part of it to punish unfair behavior. This seems to us "real" retaliation. However, the issue of whether the windfall wealth given our subjects would be spent in the same way as a permanent increase in wealth is an interesting, though quite different, issue we do not address. Thus, we believe we have confirmed KKT's conjecture that fairness serves as an added constraint on firms' rent-seeking behavior.

4. General discussion One direction for further research is clear: replicate. Future experiments should aim to avoid two important limitations of our study: (1) the subjects in both experiments were not "real" consumers and (2) the nominal retaliation costs in Experiment 2 (the distance to the other store) were not manipulated in such a way that we could measure the sensitivity of the response to the stimulus. If a large number of well-controlled experiments continue to point in the KKT direction, then the theory of the firm will need to be reworked. In particular, the modeling of consumer choice in customer markets will need to incorporate the following features: "(1) They [customers] care about

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being treated fairly and treating others fairly. (2) They are willing to resist unfair systems even at positive cost. (3) They have systematic implicit rules that specify which actions of firms are considered unfair." (KKT, 1986b, p. $299.)

Acknowledgements We wish to thank Jeffrey Leftwich and Lance Matthews for conducting the survey; Adrian Fenty, Christopher Kelkar, and Liza Oktay for performing the experiments; and Oberlin College for generous funding of both projects. We are also grateful to Judith Beinstein-Miller, Jim Zinser and participants in the Oberlin College Economics Department Seminar for helpful suggestions.

Appendix: Scenarios used in Experiment 1 1. A local hardware store located conveniently for your shopping has been selling snow shovels for $15. The morning after a large snow storm, the store raises the price to $20. You need a snow shovel to clear your driveway, etc., and the nearest store with snow shovels in stock is 10 minutes travel time away and is charging $22 for them. The next closest store is so far away that it is irrelevant to your decision. Please rate the store's action as: COMPLETELY FAIR [ ] ACCEPTABLE

[ ] UNFAIR

[ ] VERY UNFAIR

[]

Complete the rest of this question only if you checked UNFAIR or VERY tJr,rVAiR. In response to the store's action, which of the following actions would you take? D A . Buy the shovel at the local store. t~B. Buy the shovel locally but complain to the manager about the price increase. I~C. Buy the shovel locally but in the future shop elsewhere. r i D . Buy the shovel at the second store. D E . Do without the shovel. O F . Other (please specify in as few words as possible in the space below).

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2. A small photocopying shop has one employee who has worked in the shop for six months and earns $9 per hour. Business continues to be satisfactory, but a large employer in the area (an automobile assembly plant) has closed and unemployment in the area has, consequently, increased. Other small shops in the vicinity have now hired reliable workers at $5 per hour to perform jobs similar to those done in the photocopying shop by the one employee. The owner of this shop reduces the employee's wage to what the other small shops are paying. There is only one other photocopy shop convenient to you, 10 minutes travel time away, and its prices are 20% higher. Please rate this action as: COMPLETELY FAIR [] ACCEPTABLE

[] UNFAIR [] VERY UNFAIR

[]

Complete the rest of this question only if you checked UNFAIR or VERY UNFAIR. In response to the action of the owner of the photocopying shop, which of the following actions would you take? [] A. Continue doing business with the first photocopy shop. [] B. Continue doing business with the first photocopy shop but complain to the owner about his wage reduction. [] C. Make your next purchase from the first photocopy store and do your future business with the second store. [] D. Take your business immediately to the second store. [] E. Do no business with either store, e.g., you mimeograph or use a process other than photocopying. [] F. Other (please specify in as few words as possible in the space below). 3. A grocery store has stores in a large number of communities. Most of them face competition from other grocery stores. In one community the chain has no competition. Although its costs and volume of sales are the same there as elsewhere the chain sets prices that average 5% higher than in its stores in other communities. You live in a community with the monopoly store, and need to stock up with groceries for the coming week. There is only one other community conveniently located (all others are, therefore, assumed to be irrelevant) 10 minutes travel time away, and it has two stores, one belonging to the chain and one other. The non-chain store charges on average 10% more than the chain store in your community.

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Please rate the chain's action in your community as: COMPLETELY FAIR [ ] ACCEPTABLE

[ ] UNFAIR

[] VERY UNFAIR

[]

Complete the rest of this only if you checked UNFAIR or VERY UNFAIR. In response to the chain's action in your community, which of the following actions would you take? [] A. Continue shopping in my community [] B. Continue shopping in my community but complain to the manager about the high prices. [] C. Do this week's shopping locally but shop elsewhere in the future. [] D. Shop in the chain store in the other community. [] E. Shop in the non-chain store in the other community. D F. Other (please specify in as few words as possible in the space below). 4. A grocery store has several months supply of peanut butter in stock which it has on the shelves and in the storeroom. The owner hears that the wholesale price of peanut butter has increased by 5% and immediately raises the price on the current stock displayed by 5%. The only other store which sells the peanut butter you like is 10 minutes travel time and its price is 10% higher. Please rate the first store's action as: COMPLETELY FAIR [ ] ACCEPTABLE

[ ] UNFAIR

[ ] VERY UNFAIR

[]

Complete the rest of this question only if you checked UNFAIR or VERY UNFAIR. In response to the first store's action, which of the following actions would you take? [] A. Continue buying peanut butter at the first store. [] B. Continue bying locally but complain to the manager about the price increase. [] C. Buy one more time locally but get your peanut butter at the second store in the future. [] D. Buy peanut butter from the second store. [] E. Do without peanut butter. [] F. Other (please specify in as few words as possible in the space below). 5. A small grocery store employs several workers and has been paying them wages equal to the average of similar workers in the area. There is severe unemployment in the area and the company could easily replace its current employees with good workers at lower wages. The store has been making money. The owners reduce the current workers' wages by 15%.

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There is only one other grocery store convenient to you (all others are, therefore, irrelevant) 10 minutes travel time away. It has reduced its workers' wages by 10% due to the same unemployment effects. Both stores have reduced wages to levels higher than those they would pay new workers. No unions are involved, and both stores charge the same prices. Please rate the first stores action as: COMPLETELY FAIR [] ACCEPTABLE

[] UNFAIR

[] VERY UNFAIR

[]

Complete the rest of this question only if you checked UNFAIR or VERY UNFAIR. In response to the first store's action, which of the following actions would you take? [] A. Continue shopping at the first store. [] B. Continuing shopping at the first store but complain to the owner about his wage policy. [] C. Shop once more at the first store but then switch to the second store. [] D. Shop at the second store. [] E. Other (please specify in as few words as possible in the space below). 6. A severe shortage of Red Delicious apples (which you love) has developed in a community and none of the grocery stores or produce markets have any of this type of apple on their shelves. Other varieties of apples are plentiful in all of the stores. One grocer receives a single shipment of Red Delicious apples at the regular wholesale cost and raises the retail price by 20% over the regular price. All the other stores convenient to you charge, on average, 10% more than the first store for all types of apples. The only store which sells apples at the same price as the first store is 20 minutes travel time away. Please rate the first store's action as: COMPLETELY FAIR [] ACCEPTABLE

[] UNFAIR

[] VERY UNFAIR

[]

Complete the rest of this question only if you checked UNFAIR or VERY UNFAIR. In response to the first store's action, which of the following actions would you take? [] A. Buy the Red Delicious apples (if you can get there in time) from the first store. [] B. Buy only other types of apples from the first store. [] C. Buy the apples you want from the first store but complain to management about the price increase.

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[] D. Buy apples of whatever type you like at the first store once more but then switch your business to a store convenient to you. [] E. Switch your business to another, convenient store. [] F. Switch your business to the inconveniently located store. [] G. A combination of E and F, depending on the type of apple. [] H. Other (please specify in as few words as possible in the space below).

References Deng, G. et al., 1992. Fairness: Effect on temporary and equilibrium prices in posted offer markets. Working paper, Department of Economics, University of Arizona. Frey, B. and W. Pommerehne, 1993. On the fairness of pricing - An empirical survey among the general population. Journal of Economic Behavior and Organization 20, 295-307. Hoffman, Elizabeth et al., 1995. Preferences, property rights, and anonymity in bargaining games. Games and Economic Behavior (forthcoming). Kachelmeier, S.J., S.T.Limberg and M.S. Schadewald, 1991a. Fairness in markets: A laboratory investigation. Journal of Economic Psychology 12, 447-464. Kacheimeier, S.J., S.T.Limberg and M.S. Schadewald, 1991b. A laboratory market examination of the consumer price response to information about producers' costs and profits. The Accounting Review 66, 694-717. Kahneman, D., J. Knetch and R. Thaler, 1986a. Fairness contraints on profit-seeking: Entitlements in the market. American Econonmic Review 76, 728-741. Kahneman, D., J. Knetch and R. Thaler, 1986b. Fairness and the assumptions of economics. Journal of Business 59, $285-$300. Oliver, R. and J. Swan, 1989. Equity and disconfirmation perceptions as influences on merchant and product satisfaction. Journal of Consumer Research 16, 372-383. Sashkin, M. and R. Williams, 1990. Does fairness make a difference? Organizational Dynamics 19, 56-71.