Blogs | November 10, 2010

The price of fairness

One of the hot-button issues in United Kingdom political debates at the moment is the concept of “fairness”: is it fair to raise university tuition fees? Are the cuts in public spending fair? “Fairness”, like beauty, is in the eye of the beholder. But this doesn’t mean it is unimportant. Quite the opposite.

Sales people who play to our sense of fairness can end up doing very well for themselves. Perceptions of fairness matter more in economics – and indeed in everyday life – than is generally realised.

We take a stand against "unfairness"
The cleanest evidence for the importance of fairness comes from laboratory experiments with the ultimatum game. In this – it's not much of game really – one person is given a sum of money to divide between himself and someone else. If his partner agrees to the division, both get the money. But if his partner rejects it, neither gets anything. Narrow economic rationality predicts that the partner will accept any offer at all, because even a penny is better than nothing. But in practice this rarely happens (at least in western societies – but that's another story). People usually reject divisions that are worse than 70-30. This shows that people are willing to forego monetary gains in order to take a stand against what they regard as unfairness. The truth is, we see this so often every day that we barely notice. Trades unionists, for example, often lose money by going on strike and yet think the strike is necessary to advance their perception of fairness.

Fairness at the checkout
Fairness also affects how firms change prices. A recent survey by the Bank of England found that firms were quicker to raise prices after a rise in costs than after a rise in demand. A separate study – co-authored in 1986 by Nobel Prize recipient Daniel Kahneman – shows why this should be. It found that people regard price rises as fair if they are a response to higher costs, but that they regard them as unfair if they are an exploitation of market power. If customers believe they are being exploited, they might act like those ultimatum game players, and pull out of transactions that would benefit them. Fearing such a loss of sales, firms are loath to raise prices in response to increased demand.

We want to earn a fair wage
Fairness is almost certainly a key factor affecting your earnings and job. Economist George Akerlof, who also received a Nobel Prize, described labour contracts as "gift exchanges" in his research. The idea goes that employers pay more than the bare minimum necessary to hire workers, and in exchange employees work harder than is necessary to keep their jobs. A high wage is "fair" recompense for hard work, and hard work is "fair" return for a good wage. This, though, has a nasty consequence. It means that wages don't fall much in recessions, because such cuts are regarded as "unfair". Indeed, Kahneman's survey back in 1986 found that two-thirds of people think it unfair for a profitable firm to cut wages in response to unemployment. And if workers feel they are treated unfairly, they might work less hard and withdraw goodwill potentially damaging the firm. But under these theories, wages won't fall to price jobless workers back into work. And unemployment stays high.

Is it fair? Beware: gifts can create obligation
There's another effect of the perceptions of fairness triggered by gift exchange – and this one plays to our sense of obligation and can cost us money. Back in the 1960s, Cornell University psychologist Dennis Regan ran a little experiment, trying to sell raffle tickets to people. He found that he sold twice as many tickets to people if he had offered them a bottle of Coca-Cola a few minutes earlier. But here's the thing. The drink cost only 10 cents, whilst the raffle tickets cost 25 cents. His "gift" earned him a return of 500%. Salesmen and charities exploit this. Little gifts, special offers and small free "tasters" create a sense of obligation, and our desire for fairness causes us to discharge such obligations more than fully, by buying or donating more than the value of the gift. This is where we should be on our guard. Our sense of fairness and obligation can cost us money. We're tempted to buy that expensive car because the nice salesman has gone to so much effort to knock a few hundred pounds off the price. Our taste for fairness can be an expensive one.


Chris Dillow
Chris Dillow

Investors Chronicle writer and economist