Perceived Price Fairness and Dual Entitlement

ABSTRACT - A principle of price fairness called "Dual Entitlement" proposes that it is fair for sellers to pursue a pricing rule of raising prices when their costs increase, but not reduce their prices when costs decrease. In this study the fairness of this rule is tested against an alternative cost-plus rule and a buffer rule, both of which were observed to be more fair than the rule derived from the Dual Entitlement principle. Situational effects are also demonstrated which raise questions as to whether any general norms of fairness exist in pricing decisions.

Citation:

Rosemary Kalapurakal, Peter R. Dickson, and Joel E. Urbany (1991) ,"Perceived Price Fairness and Dual Entitlement", in NA - Advances in Consumer Research Volume 18, eds. Rebecca H. Holman and Michael R. Solomon, Provo, UT : Association for Consumer Research, Pages: 788-793.

Advances in Consumer Research Volume 18, 1991      Pages 788-793

PERCEIVED PRICE FAIRNESS AND DUAL ENTITLEMENT

Rosemary Kalapurakal, Ohio State University

Peter R. Dickson, Ohio State University

Joel E. Urbany, University of South Carolina

ABSTRACT -

A principle of price fairness called "Dual Entitlement" proposes that it is fair for sellers to pursue a pricing rule of raising prices when their costs increase, but not reduce their prices when costs decrease. In this study the fairness of this rule is tested against an alternative cost-plus rule and a buffer rule, both of which were observed to be more fair than the rule derived from the Dual Entitlement principle. Situational effects are also demonstrated which raise questions as to whether any general norms of fairness exist in pricing decisions.

INTRODUCTION

Traditional price research has focused on economic determinants of price-setting. However, in recent years, many researchers in economics and other fields have attempted to enrich the model of the agent by including "nonrational" motives. This paper examines one stream of research focusing on consumers' judgments of price fairness: whether and how subjective preferences for 'equitable,' 'just' or 'fair' prices influence behavior.

Price Fairness

Research in the area of price-perceptions has many diverse branches, some of which will be examined briefly in this section. In Marketing, the relevant stream of research has focused on the 'psychophysics of price,' building up conceptual and empirical support for the effect of various price perceptions on determinants of price acceptability, including price fairness (Kamen and Toman 1970), price-quality perceptions (Monroe 1973) and reference prices (Klein and Oglethorpe 1987). Although Kamen and Toman (1970) find support for the proposition that "consumers have some preconceived ideas about what is a fair price for a given item and are (only) willing to pay this price or below...," they do not examine the notion of what constitutes a 'fair' price to consumers. In Economics, researchers have included fairness in the consumer's objective function for a variety of economic reasons, including anticipation of hostile consumer reaction to unfair treatment (Okun 1981) and concerns about building up trust and goodwill over time (Akerlof 1970; Arrow 1973).

The immediate impetus for the present work comes from two recent papers which put forward two important claims: (1) that community norms of what constitutes a fair price may influence the pricing behavior of firms and (2) that a 'Dual Entitlement' principle (hereafter referred to as the "DE" principle) determines such norms (Kahneman, Knetsch and Thaler 1986 a; 1986 b). According to these scholars, a supplier may examine the fairness of its intended pricing tactic as judged by community standards. If it is not fair, the supplier will be less likely to go ahead with its planned pricing tactic. Moreover, these researchers propose that the constraining motive could be primarily moral, and at times, dominate the purely economic motives of avoiding loss of customer goodwill and jeopardizing long-term profits.

Few would argue that ethics do not influence human behavior, including economic behavior. Business enterprises often sacrifice their economic interest in many unheralded ways through charitable donations, special consideration of employees and community services. What is controversial is the claim that the incorporation of norms of price fairness- into the traditional economic theory of buyer and seller behavior results in a parsimonious extension of the theory, whereby it can correctly specify when and how norms of fairness will modify the basic model of these economic agents (Kahneman, Knetsch and Thaler 1986a, p. s299).

The Dual Entitlement Principle. Kahneman et al demonstrate that consumers do form subjective judgments about the fairness of various prices (1986a; 1986b). In addition, their experimental research (1986a) indicates a willingness on the part of subjects to "punish" unfair pricing behavior, even at some cost to themselves. However, the present focus is on their findings regarding the conceptualization of the "community norms" of fairness.- On the basis of their survey findings, they concluded that standards of fairness are based neither on a strict cost-plus rule (output price should be related to input costs) nor on the "law" of supply and demand (charging what the market will bear). Rather, it is suggested that they are governed by a 'Dual Entitlement' principle. This principle proposes that sellers and buyers are entitled to the profit and price terms, respectively, of a "reference" transaction. Possible reference points may include the most recent transaction or an 'average' transaction (see Klein and Oglethorpe 1987). The reference transaction serves as a yardstick against which the terms (price and profit) of the current transaction are compared, in arriving at judgments of fairness. The DE principle implies that it is not fair for sellers to increase the price to the buyer in order to exploit increased market power (such as when demand increases). Similarly, if there is increased supply, it is not fair for prices to be lower to the consumer because it would violate the terms of the reference transaction.

However, the most intriguing aspect of the proposed formulation is its claim that the seller's profit entitlement takes precedence over the buyer's price entitlement whenever both are threatened. This implies that it is consistent with community norms of fairness for cost increases to be passed on to consumers in the form of higher prices, in order to protect the seller's reference profit. Moreover, the DE principle effectively implies that the supplier is allowed to increase its profits when there are cost reductions. The buyer is only entitled to the current reference price and not to a share of the cost savings in the form of a lower price. If, over time, such increased profits become the 'expected' level of seller profits, they are further protected when costs increase. In short, it is fair for prices and profits to only ever increase, because it is consistent with this norm of fairness for sellers to pass on cost increases and not cost decreases.

We agree with Kahneman et al that "rules" of fairness in the domain of supplier pricing behavior should not be intuited or inferred from conventional economic theory (Kahneman,Knetsch and Thaler 1986a, p s299-300) but should be empirically established. If the DE principle is indeed a principle (i.e. a basic truth, law or doctrine that embodies community norms of fairness), then its discovery is an important advance in economic ethics and political economy. It merits further examination because it favors the supplier and argues that aspects of the standard free-market clearance mechanisms are unfair.

Context and the robustness of the DE principle. The context in which decision problems are presented can give rise to different preferences, even if the objective information remains invariant (Kahneman and Tversky 1984). Examples of framing biases in perceptual judgment issues are common and have been raised in the well-known work on prospect theory (Tversky and Kahneman 1986). A way to explore the robustness of the Dual Entitlement principle therefore, is to examine the effects of different perspectives on subjective perceptions of fairness. Indeed, Kahneman et al themselves conclude that "..judgments of fairness are susceptible to substantial framing effects" (1986b, p. 740). What we demonstrate is that the judged fairness of pricing rules are indeed subject to some important contextual effects. The consideration of these effects leads to some different conclusions about fairness, as well as about the robustness and generalizability of the DE principle.

Research Issues

The present research questions the empirical evidence supporting the DE principle and attempts to examine further the determinants of judgments about fairness. Specifically:

(1) The initial experimental scenarios were designed to replicate the findings that the DE principle embodies a "community" norm of fairness. The DE implication that cost-based price increases are more justified than exploitation of market power was also examined.

(2) Following from our discussion of the fairness of alternative pricing strategies, the next set of experimental scenarios focused on whether the DE rule is, in fact, considered to be more fair than (a) a cost-plus rule (b) a brokerage rule and (c) a "buffer" rule (where the seller does not pass on cost increases).

(3) Finally, other contextual factors were examined in order to determine how sensitive judgments of fairness are to situational elements. Such factors include information about the seller's past pricing strategies and whether the passing on of a cost increase was initiated by the seller or was a competitive response. Additional contextual factors include personal relevance (in tern s of economic consequences) of the proposed action and the identity of the actor (seller or buyer).

METHODOLOGY AND RESULTS

The robustness of the DE rule was tested empirically by placing the reported pricing behavior of the firm within different contexts or frames. A set of four pricing scenarios were presented to a sample of 189 business students. Two earlier studies of business students (sample size 105 and 78 respectively) were also undertaken, which helped in the preparation of the final experimental scenarios. These studies produced a similar pattern of results and hence the details are not reported.

In each scenario, the context was systematically manipulated by presenting different scenarios describing a seller's pricing decision to subjects in different treatment conditions. All manipulations were between subject. Subjects read the scenario and then responded to a series of scales about the perceived fairness of the pricing action taken by the seller. The order of presentation of the four cases was also manipulated and had no effect on the subjects' responses.

Our examination of the research issues detailed above is presented in the following sections. A description of the scenarios in each instance is provided, along with the results and a discussion of the implications of each.

The Effect of Illustrating the Complete Rule on Fairness. Our concerns over potential framing biases can best be illustrated by using the following question, the answers to which have been pivotal in the research supporting the DE principle:

"My first questions are about the behavior of people in business. Suppose a factory produces a particular table, which it sells to wholesalers. The factory has been selling all of the tables it can produce for $150 each. Suppose that the factory has now found a supplier who charges $20 less for the materials needed to make each table. Does fairness require the factory to change its price from $150 in this case?" (Respondents who answered yes were then asked what is a fair price that it could charge to the wholesalers).(Kahneman et al 1986a, p.s293)

The first issue is that the above scenario cannot be regarded as a complete test of either the cost-plus or the competing DE rule because it does not describe the history of the application of the rule; in particular, it does not describe what the factory would do if faced with a $20 increase in its cost of raw materials. The fairness of the cost-plus rule may well depend on a give-and-take sharing norm. In fact, Kahneman et al suggest that "...it remains possible that respondents might follow a cost-plus rule if asked to consider together the appropriate price response to increases and to reductions of costs" (Kahneman, Knetsch and Thaler 1986a, s295). The absence of information explaining what the factory did when it last faced a cost increase of $20 may, therefore, have biased responses in the Kahneman et al study; it is plausible that some percentage of subjects may have assumed that the firm would absorb any cost increase that might occur as well. Therefore, this effectively tests the application of only half the rule, the perceived fairness of which may depend critically on how the other half of the rule was executed.

To explore this issue, the above scenario was contrasted with two others, which provided a historical context on how the manufacturer had handled a past cost increase. A "buffer rule" version included the following information prior to the description of the critical pricing situation: "...Recently it absorbed this cost increase and did not raise it selling price." A final (Dual Entitlement) version stated: "...Recently the factory experienced an increase of $20 in its cost of materials. It raised its selling price by $20 to $170 each." Subjects were required to evaluate the fairness of maintaining the price at $170 when input costs fell by $20, a condition consistent with the fairness implications of the DE rule.

Of the subjects responding to the original scenario 65% (41/63) indicated that it was quite fair for the factory to keep charging $150, a result consistent with the findings of Kahneman et al. Moreover, this figure jumped to 91% (58/64) when they were informed that the seller had "buffered" the cost increase in the past. However, the effect of the historical information in the third scenario (the complete DE rule) was dramatic: now only 63.5% (33/52) thought it was fair to continue charging $170 in the face of a cost decrease of $20 (p<0.0001).

Viewed one way, it can be argued that this result provides support for the fairness of the DE principle. More than half the subjects perceived the application of the complete DE rule to be fair. Moreover, on average, it was felt that only $8.64 of the $20 saving needed to be passed on to the shopper (the average fair price suggested by this group was $161.36). From another perspective however, these findings suggest that the proposition that the DE rule represents the community norm of fairness is somewhat misleading; the buffer rule was considered by a much higher percentage of subjects to be fair compared to the DE rule (91% vs. 65%, p < 0.001).

Testing the complete rule appears to be especially important when we consider the possibility that regular customers' perceptions of the fairness of a firm's pricing behavior may well be based on the history of its behavior rather than on a single incident. In particular, industrial consumers, 0 who are likely to be aware of changes in input prices, will judge the fairness of a firm's pricing policy not just on its last behavior but also on its consistent application of a pricing rule over time. Pricing decision-makers should accordingly, be more interested-in consumers' perceptions of the application of the complete DE price-rule.

Fairness and Consistent Treatment of Cost Changes. In examining the robustness of the DE principle, a factor to be considered in the formation of judgments about fairness is whether or not the seller behaves in a consistent manner with respect to price increases and decreases. To study this issue further, subjects were presented with the following scenario:

A department store has been buying an oriental floor rug for $100. The standard pricing practice used by department stores is to price floor rugs at double their cost so the selling price of the rug is $200. This covers all the selling costs, overheads and includes profit. The department store can sell all of the rugs that it can buy. Suppose because of exchange rate changes the cost of the rug rises from $100 to $120 and the selling price is increased to $220. As a result of another change in currency exchange rates, the cost of the rug falls by $20 back to $100. The department store continues to sell the rug for $220.

As seen here, fluctuating exchange rates was cited as the reason for both an initial increase in cost and a subsequent decrease in cost of the rugs. It has been observed that changes in currency values are a nice test of the DE principle because it can be observed that resulting cost increases are passed on quickly but resulting cost decreases tend not to be passed on (see Kahneman, Knetsch and Thaler, 1986a, p. 739). This scenario is a direct test of the full DE principle i.e. an initial cost-plus price increase -no subsequent price decrease rule is described. In this scenario, the mean rating of the above pricing behavior that fully describes the application of the DE principle was -0.4 (-3: extremely unfair; +3: extremely fair).

In contrast to the DE formulation, two more price-behavior scenarios were presented, which described the consistent application of a cost-plus or brokerage rule to both the price increase and decrease. In the first (cost-plus) scenario, the price was increased (decreased) by $20 when the cost increased (decreased) by $20. In the brokerage scenario, when the cost increased (decreased) by $20, the store increased (decreased) the price by $40. Although the average rated fairness in the cost-plus and brokerage conditions were not significantly different from each other (+2.3 and +2.2 respectively), the behavior consistent with the full DE principle was rated as being significantly less fair than behavior describing the consistent application of the cost -plus rule or the brokerage rule (+2.3 versus -0.4, +2.2 versus -0.4, p < 0.0001 in the respective contrast tests).

This test thus provides further support for our claims that judgments of fairness are based on a historical perspective rather than on the present situation alone. The consistent application of the cost-plus or brokerage rules to both cost increases and decreases is considered much more fair than a rule which only applies to cost increases and hence favors the supplier (i.e. the DE rule). This suggests therefore, that sellers may be able to pursue a pricing policy consistent with the DE principle, not because it reflects community norms of fairness but because of information asymmetry between supplier and consumer: buyers may not have enough information about a firm's pricing practices, and in particular, may not know about the cost decreases that have not been passed on to them.

The Effect of Cost Increase Justification on Fairness Ratings. As proposed by Kahneman et al, a theory of fairness governed by the provisions of the reference transaction implies that cost-induced price increases will be assessed by consumers as being fair whereas price increases resulting from a shortage in supply and exercise of market power by a seller will not be perceived as fair: the latter violates the buyer's entitlement to the reference price even in the absence of a threat to the seller's reference profits. These propositions were tested and confirmed in the present study.

Subjects were presented with two scenarios describing a local shortage of lettuce and the pricing responses of sellers. In the first situation, a wholesaler responds by increasing the price of lettuce by 30 cents a head to a retailer (grocer) who passes on this cost increase to his customers. Although this is a straightforward test of the fairness of cost-induced price increases, it is interesting to note that it is the wholesaler's exercise of market power that produced the 30 cent price increase. To check on whether respondents object to a supplier directly taking advantage of the forces of supply and demand, a second group of subjects was informed that the grocer "grows his own lettuce rather than buy from wholesalers," implying that his costs would be unaffected by the wholesale price increase. This grocer also responds by increasing the price of lettuce by 30 cents a head.

Our results show that while the action of the grocer in raising the price of lettuce to match the wholesale cost increase was still considered fair on average, it was significantly less so than in the situation where the price increase is cost-induced at the retail level (+2.3 versus +0.8, p < 0.0001). This supports the proposition that the use of a market clearance pricing rule is not considered as fair as a cost-plus rule. It also suggests that the price increase is considered more justifiable when it is initiated by some unknown channel intermediary rather than the retailer because the latter is seen has having no option but to pass on costs. This issue is examined in greater detail in the next section.

Is Initiating a Price Increase Less Fair than Following? Another factor that may moderate judgments of fairness of various price-setting behaviors by a party is information as to who initiates the price increase. In order to test the significance of this factor, the previous "lettuce" price-setting scenario also included conditions in which information was provided as to whether the price increase at the retail level was initiated by the grocer or by a competitor. The question of interest is whether the supplier's pricing behavior will be considered less fair if it initiates the price increase in contrast to a situation where it is a tactical response to a price change by a competitor, regardless of the price justification. The answer is a marginal yes; when the grocer initiated the price increase in response to a cost increase, the price increase was still considered fair but, as predicted, significantly less so than when competitors raised their prices and the grocer followed (average rating +1.06 vs. +1.61, p < 0.05: one-tailed test).

The Effect of Personal Relevance on Perceived Fairness. Underpinning the DE principle is the concept of an ethical "community" norm. However, if self-interest is a motivating factor, then the individual buyer's perspective does matter. It was expected that the behavior of the seller might be rated less fair when it was likely to have a direct adverse effect on the judge. A possible explanation for any difference in evaluations would therefore be that economic self-interest is an important antecedent of buyers' fairness judgments; the latter are not driven purely by moral issues.

The significance of this factor was studied using the first pricing behavior scenario (the manufacturer of the table) described earlier. Half the respondents were asked to imagine that they themselves were the customer ("Imagine you are a customer wanting to buy such a table.") This manipulation of orientation had no statistically significant effect on the rated fairness of the manufacturer's pricing behavior. In retrospect, perhaps this is not surprising, as such role playing is a rather weak manipulation of personal relevance.

Is Fair Bayer Behavior Rated Unfair When Sellers Do It? The research undertaken by Kahneman et al found that price increases related to excess demand are generally considered to be unfair. A related issue of interest is whether the relative fairness of the exercise of market power depends on whether it is the supplier or the buyer who exercises market power. Assuming that student subjects will be inclined to identify with the buyer (as members of the consuming public themselves), it was expected that it would be considered more acceptable for a buyer to exploit market conditions than for a seller to do so. This was tested in the following way. Subjects were asked to rate one of the following two scenarios:

A car dealer has in stock the last of an exclusive automobile for which he has several potential customers. He contacts the customers and plays them off each other to obtain the highest price for the car. (Average rated fairness: +0.85)

A new car buyer visits several dealers who stock a particular model he wishes to buy. He plays them off against each other to obtain the lowest price for the model that he wants to buy. (Average rated fairness: +2.9).

The results indicate that adopting the perspective of one or other party in the exercise of market power has a significant influence on perceptions of fairness; it was considered more fair for the buyer to exploit market power than for the seller to do so (p < 0.0001). Even in a scenario where the buyer was described as resorting to deceit (exaggeration of the lowest price offered by other dealers), it was still perceived to be at least marginally fair (average rating: +0.7). It is clear that a different standard of fair play is applied to buyers than is applied to sellers and that it favors the buyer, at least for respondents who identify with the buyer rather than with the seller.

DISCUSSION

The present set of experiments raise a number of issues which modify and extend the interesting and original work of Kahneman et al. Consistent with the first issue, our findings replicate the previous research in that we find strong evidence that respondents can and do make evaluations of fairness that are significantly influenced by various economic and non-economic factors. We find some support for the suggestion made by Kahneman et al (1986a; 1986b) that pricing behavior favoring the supplier is, on average, considered fair. Its implications in terms of differential evaluations of fairness of cost-based versus market-based responses are also supported here. Moreover, this research indicates that the reference transaction plays an extremely important role in shaping such perceptions.

However, there are additional interesting findings in the present work that are worthy of further discussion. One major finding is that the case for the Dual Entitlement principle may not be as strong as argued by Kahneman et al. Our research suggests that a buffer rule (absorbing cost increases and decreases) or a cost-plus rule applied consistently to cost increases and decreases is considered to be more fair than the DE rule.

A second important implication is that situation norms determine what is judged to be fair or unfair pricing behavior. Inasmuch as perceptions about the situation depend greatly on the level of knowledge or ignorance of the judge, we might expect considerable variance in how buyers and the community view the fairness of a supplier's behavior. In addition, the efforts of the supplier to cast its behavior in a more favorable light and the efforts of its competitors to expose the same behavior as "selfish opportunism" will increase the uncertainty and variance in perceptions of the fairness of a supplier's action. This conclusion may need to be modified even further as a result of future studies which consider an increasing number of situational factors. The motivation behind such studies is the need to develop the theory of the subjective perceptions of price fairness. An important and related issue is whether issues of fairness really do influence buyer and seller behavior over and beyond the long-term economic interest of the buyer and seller.

Limitations and Issues for Further Research

The present study suffers from a number of limitations. From a methodological viewpoint, it was necessary to test our propositions using scenarios rather than a behavioral format. Each subject was allowed to arrive at his/her own definition of "fairness" no definition was provided by the researchers, and this may have increased the random variance. Moreover, a single-item scale was used to measure subjects' perceptions of fairness. A multi-item scale would have been a more appropriate measurement procedure, given the subjective nature of the construct. The "community" norms of fairness examined here may not be generalizable to sections of society other than students (although the initial findings are consistent with the Kahneman et al surveys of the general public). Finally, subjects' perceptions of fairness were explicitly solicited. An attempt to assess the importance of "nonrational" issues such as fairness perceptions in buyer-seller interactions would have greater validity if such judgments were unsolicited, occurring 'naturally' in response to the description of a seller's pricing decision. As such, we do not test the relative importance of subjective considerations such as fairness against the more objective economic factors in the formation of purchase and consumption decisions.

In the present research, we studied the fairness perceptions of business students, acting as consumers. However, this stream of research clearly has important implications for seller pricing perceptions as well. In fact, if sellers do not ever consider community norms of fairness in making pricing decisions or are unaware what these norms are, then the whole issue is rather academic. It is possible that sellers apply industry-specific norms of fairness, if they apply them at all. Community norms pertaining pricing practices have a variety of antecedents, of which we focus only on the ethical one. It is left to future research to determine what other antecedents may be relevant. Moreover, it may prove useful to determine what subjects consider to be fair in more detail, and study how they arrived at that determination.

In conclusion, we suggest that (1) since fairness evaluations appear sensitive to situational factors and information available, there may be no simple robust principles that govern norms of what is fair or unfair pricing behavior (2) such contextual factors include, amongst other things, the judge's self-interest and involvement in the transaction, knowledge about a supplier's initial costs and profit margins and information about a supplier's past pricing behavior and competitors' behavior. Both the conceptual and empirical explorations in the present study indicate limits to the generalizability of the Dual Entitlement principle. Our empirical results show that, given sufficient information, other pricing rules are perceived to be more fair. However, on the basis of our findings, no specific rule can be claimed to embody community norms of fairness.

REFERENCES

Akerlof, G (1979), 'The Case Against Conservative Macroeconomics: An Inaugural Lecture," Economica, 46 (August), 219-237.

Arrow, Kenneth (1973), "Social Responsibility and Economic Efficiency," Public Policy, 21 (Summer), 303-317.

Kahneman, Daniel, Jack L. Knetsch and Richard H. Thaler (1986a), "Fairness and the Assumptions of Economics," Journal of Business, 59(4), pt.2, s285 -300.