(Un)Fairness – Part 1
Economists and social scientists have always been fascinated by fairness, and what defines our perception of it. As straightforward as it seems to talk about fair behavior, defining it, however, is rather complex: after all, it all depends on individual perception. The radical view is more of an egalitarian point of view, where deviations from the norm are considered to be unfair. However, we do have to keep in mind that fairness and justice are two very different things. I do not wish to give you a “true” definition on fairness (philosophers way more knowledgeable than me have failed to do so), but rather, how important our perception is on fairness, how it affects economics, and whether a fairness-seeking behavior is rational.
I’m going to make him an offer he can’t refuse: Ultimatum Game
One of the most commonly used games in economics is the ultimatum game. The rules are simple: two players have to divide $10 among themselves. The first player does the division, which the second player can either accept or refuse. However, each of them will only receive their part of the money if the second player accepts the offer. Because of this, the first person has to offer a reasonable amount of money to the second player in order to get anything.
Stop for a second and think: If you were the first player, how much would you offer to the other player?
Unless your answer was 0.01$, your expectations are not rational. If they were, then you would assume that the second player’s actions won’t change whether he gets one cent or nine dollars: in each case, he would be better off than he was previously. However, results show that modal offers are, in fact, 50% of the pie, while the mean of the amount offered is around 40%. Two things come from this: first, people tend to make fair offers, fearing that it might be refused otherwise. And indeed, offers where the offered money was less than 25% of the total, being perceived as inequitable, were commonly rejected. However, if one is aware of the fact that receiving $1 should not be relative to the other person’s gain, then people tend to accept smaller amounts of money. This is why, for example, in one version of the game, economics students (being primed to be more self-interested) offered less and were willing to accept less money in ultimatum games (Carter and Irons, 1991).
Second is that one of the important factors during the division is entitlement and legitimacy, meaning – for what reason, and who is the one with the power to make the offer. In one version of the game, the roles were decided on the basis of performance in a trivia quiz, with the winners becoming the proposers. The proposers were told that they won this right by being smarter, thus gaining public entitlement. When it came to games where people “earned” the right to be proposers, offers were more parsimonious. The proposers appeared to believe that the responders would be willing to accept more modest offers. Surprisingly, however, the receivers were not willing to succumb to this newly-given-authority, resulting in a rise in rejection rates. This has been tested with games played with $10 and $100, and the results were nearly the same (Hoffman et. al. 1996).
Ultimatum game has a very interesting implication: those who were making the offers were doing so to maximize their own expected payoffs (which is consistent with mainstream economics’ self-regarding preferences and “selfishness”). However, those players who rejected had not concentrated on themselves, but rather the difference between their payoffs and that of the other player. Instead of benefiting from receiving some money, they chose to punish the other person for not being fair.
Fair play in the markets
According to Okun (1981), a failure to conduct business in a fair manner could distort consumer markets, which in turn leads consumers to reduce their expenses due to loss of trust in the market. In his view, the supply side has the power to set the prices, and at times it can even have monopolistic power (although he does not mention it, demand side obviously has tools to indirectly affect prices). In essence, Okun found that consumers react in a hostile way to all price-increases which are not justified with some cost-increase. However, they tend to accept “fair” increases if supply stagnates or decreases, due to realizing that otherwise, the business would go bankrupt.
In their research, Kahneman, Knetsch and Thaler (1986) aimed to find patterns in the perception of fairness using survey data. They wanted to find “social norms” in fairness regarding pricing, wage negotiations and rent changes. Also, they were interested in quantifying the effects of unfair behavior in the markets. They used reference-transactions as anchoring (see our blog on anchoring effect) in order to define a superficial “norm”, then they tested how people react to the deviations from this norm. They were curious whether price-changes can be justified in three situations. Are these changes fair, when:
the firm’s profits increase,
the firm’s profits decrease, or
due to structural changes in the market, the firm’s profits increase.
Results, though not exhaustive, suggested that:
Increases in prices (even significant ones) are considered to be fair when it is preceded by increases in commodity prices, making production costs and costs in general higher. But the firm can only “defend itself” from cost-increases related to the transaction at hand.
Consecutively, if the previous point is accepted, it is generally considered to be unfair when benefits from decreasing costs are not shared with other stakeholders.
Increases in profits are deemed fair if it isn’t related to the losses suffered by the consumer.
One of the key findings regarding the perception of fairness is the phenomena of “dual entitlement”. In short, this states that the sellers have an entitlement to achieve their reference-profits, while customers are entitled to the conditions of the reference-transactions. Consecutively, the transactions deemed “fair” are not necessarily fair from an objective point of view – that is, they are not necessarily “just”.
I’m having what he’s having
As we can see, preferences commonly used in economics might not work in certain situations such as the ones presented by the ultimatum games. Due to this, institutional and behavioral economists came to the idea of using “social preferences” and the concept of “homo equalis”, which can still be mathematised, but can explain a number of economic choices within social context. This will be elaborated on in our next blog, stay tuned!
References and Further Readings
Carter, J., & Irons, M. (1991). Are economists different, and if so, why? Journal of Economic.
Franzini, M. (2017): Institutional Economics – lecture notes. Universitá di Roma “La Sapienza”.
Hoffman, E., McCabe, K. and Smith, V. (1996) On expectations and the monetary stakes in ultimatum games. International Journal of Game Theory, 25: 289–301.
Kahneman, D., Knetsch, J, L. & Thaler, R. H. (1986): Fairness as a Constraint on Profit Seeking: Entitlements in the Market. American Economic Review, February 1986.
Okun, A. (1981): Prices And Quantities, A Macroeconomic Analysis, Washington: The Brookings Institution, 1981.