Businesses want us to view them as fair – there is arguably nothing more important than a reputation for fairness in the daily marketplace of commercial transactions. As business managers what can we do to ensure that decisions we make – about pricing or other actions that are clearly visible at the point of the customer-product interaction – will be seen as fair? Is fairness something absolute, immutable and precisely quantifiable? Or is it situational, capricious and ever-changing? The bad news, perhaps, is that ‘fairness’ is a very elusive notion to pin down with certainty – it’s hard to put fairness in a bottle and label it as such. The good news is that fairness more than anything else is about perception and the relative judgments of your customers and potential customers in varying demand situations. That’s good news because the better you understand the granular contours of your demand environment and the precise needs and propensities of your customers, the more likely you are to understand how to make decisions in that environment that are both fair to the customer and profit-optimizing to your business.
Here’s a test of fairness. Imagine you are lying on the beach on a hot summer day and find yourself craving a cold, satisfying beer. What price would you be willing to pay to quench your thirst? Now imagine two alternative scenarios. In one, the only place within walking distance to buy a beer is the poolside bar of a swanky five-star beachfront hotel. In the other, there is a rather run-down beachfront grocery store that sells beer. Imagine further that both the hotel and the grocery store sell the exact same brand and type of beer. Does your maximum price point change depending on whether you think you are getting the beer from the hotel or the store? Do you think it is fair for two different establishments to sell the same commodity for a different price?
Those questions were at the heart of a study by a team of behavioral economists and reported in the Journal of Business in 1986 (“Fairness and the Assumptions of Economics” by Daniel Kahneman, Jack Knetsch and Richard Thaler). Participants (playing the role of the thirsty beachgoer) were told where the beer would come from (ritzy hotel or rundown grocery store) and asked what their maximum permissible price would be. The results were interesting: respondents who thought their beer was coming from the downmarket store were willing to pay a maximum $1.50 while those who were told the beer would be purchased at the luxury hotel were prepared to shell out $2.65.
What’s so fair about that? We have to assume that, give or take, the procurement cost to each vendor was roughly the same. The results of the study seem to indicate a calculus in the minds of the respondents that the beer will inevitably cost more if it comes from the hotel, so they were willing to adjust their own demand curves upwards to meet the perceived point of supply, as opposed to boycotting the transaction opportunity because of a perhaps unfair price differential. Instinctively that makes sense to me. Putting myself in the position of the parched beachgoer in the shadow of the ritzy hotel I think I would be more likely to go along with the reality of the $2.65 hotel beer than take a principled stand on the arguable unfairness of a 77% markup. My experience tells me that it’s simply the way these things work, like it or not. The results of the Kahneman study say largely the same thing: despite a potentially strong case to be made for the unfairness of the hotel’s pricing scheme, most people willingly go along with its reality and adjust their own internal pricing mechanisms accordingly.
Most of us have been somewhere where we have paid much more for something than we would otherwise – the infamous mini bar and local telephone call surcharges in hotel rooms come to mind. Ordering a bottle of wine in a restaurant brings about the same experience – I know that a particular 2005 Gigondas retails for $18 at the local wine store but I’ll have to shell out $40 for the same quaff over candlelight and soft music at that romantic little cuisine provençale place down the street. That $8 bag of peanuts or $40 bottle of wine become reference points – prices we anchor in our brains as reflective of actual experience, and call upon each time we are presented with similar transaction opportunities. In this process a subtle shift takes place; we are no longer focused on the inherent fairness or not of the underlying state of affairs (high markups in restaurants and hotels) but rather on the fairness of any transaction offered to us in relation to its reference point. So, going back to the sun-baked beach, if someone offers to go buy a beer for me and tells me the only option is from the hotel bar then my brain calls up the reference point of prior hotel-based transactions and I set my maximum price accordingly. That $2.65 is an imprecise stab at establishing a benchmark for what the hotel bar should charge for my drink, and as long as it is somewhere in that neighborhood I am okay with the purchase.
Luis Saravia de la Calle, a member of what was known as the Salamancan School of the Late Scholastic period in 15th century Spain, stated that “the just price of a thing is the price which it commonly fetches at the time and place of the deal.” Interestingly the Salamancans strongly influenced the philosophies of later Austrian School thinkers like Joseph Schumpeter, but also seem to resonate with the more recently emergent tenets of behavioral economics avatars like Kahneman (the 2002 Nobel laureate in economics) and the late Amos Tversky. In this line of thinking fairness is not some arbitrary notion of a justifiable price based on component costs of production and delivery (like a cost-plus model); if it were, then more people would throw down the gauntlet at the prospect of shelling out 77% more for the same beer just because of where it happens to be sold. It’s more along the lines of de la Calle’s notion of what prevails at the “time and place of the deal” – which is also what we at Sentrana think of as Pricing 4.0 – the intricate configuration of the needs and propensities of each individual customer at the point of interaction with each individual product.
We may not be able to pinpoint the precise meaning of fairness at all times and all places for all people. But by better understanding the reference points that anchor buying and selling decisions in the micromarket we have an improved chance of achieving results that are both fair and profitable.