(image: NeuPaddy)

Fairness or efficiency?

Yet another instance of the tension between our emotions and economic logic

Imagine a clothing retailer who charges more for an item in a larger size than for an almost identical one in a more mainstream size. While you’re at it, imagine a supermarket increasing the price of food during rush hour, and for good measure, also an energy provider with more expensive electricity at peak times.

You’d be imagining the kind of practices that quickly receive the label of unfairness. In the summer of last year, fashion retailer ASOS was found to sell a dress in size 18 for £10 more than a very similar one in size 6–16. The reactions were predictable at the time. A year on, it featured in the BBC consumer show You and Yours earlier this week, suggesting that the outcry over this kind of ‘fat tax’ has not quite died down.

A Mail Online article last week headlined: “Supermarkets could use ‘e-pricing’ to jack up the cost of food during lunchtime and after-work rushes”. It supports its prediction that “a shift towards surge pricing is extremely likely” with quotes from a consumer psychologist and a retail strategist. It’s not quite happening yet, but the comments below the article suggest that it would surely not be seen as a fair move. (Uber knows all about the questionable popularity of surge pricing.)

Oversize, overprice (image: sumonpcs)

And the introduction of smart energy meters in the UK enables suppliers to introduce ‘Time of Use’ pricing. This goes well beyond the conventional dual-tariff system, which charges less for electricity used during the night (when demand is low). Greenenergy UK was the first to introduce such a flexible tariff, with a night time rate of 4.99p/kWh between 11pm and 6am, and a standard rate of 12p during the day, but with a peak tariff of 25p between 4pm and 7pm on weekdays. As a paper on so-called cost-reflective pricing by Elisabeth Hobman and colleagues states: “there remains a common public perception it is harmful and unfair. In particular, variable pricing is thought to harm ‘vulnerable groups’, specifically, those segments of the community with limited capacity to reduce energy usage during peak times, e.g., low-income households, those with disabilities or medical/health issues, shift workers, and young families with many children.”

Yet the importance of fairness in economic transactions is not a new topic. In Fairness as a Constraint on Profit Seeking: Entitlements in the Market, a paper from 1986, Daniel Kahneman, Jack Knetsch and Richard Thaler describe a classic lab experiment. They read the following scenario to 107 participants: “A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.” When they asked the participants to judge the action of the store owners, 82% thought that it was unfair or very unfair.

Conventional economic theory does not take into account such emotional judgements, focusing instead on efficient allocation of resources. By raising the price of what has become a scarce good, the hardware store owner ensures that the shovels will be bought by those to whom they are most valuable. In other words, the shovels should end up where they provide maximum utility.

Economic efficiency is of course also behind differential pricing for energy. The technical constraints of the way energy is generated mean that it is tricky and costly to ensure supply always matches demand. Peaks and troughs are therefore best avoided, and a dynamic price is a simple and effective way of signalling this to the consumers. They can then choose to adapt their consumption accordingly. The same applies to (currently still hypothetic) surge pricing in supermarkets. The need for extra staff during rush hour is expensive. If this is not recharged to the peak time consumer, it raises the overall cost for everyone. So here too the price signal may work as an incentive for consumers to consider shopping at a less busy time.

The argument for more expensive ‘plus’ size clothes is slightly different. Larger items may require a bit more material, but that justification is hard to maintain if the price for sizes 6 and 16 is the same. More plausible is the explanation is that demand for outlier sizes is considerably less than for mainstream ones, and therefore also more volatile. This volatility represents a risk for the retailer. The clothes rails at the end-of-season sales tell the story: they tend to contain mostly the less common sizes. As the proportion of unsold items that now need to be discounted is higher, one way to sustain overall profitability is to sell them at a higher normal price. Failing to do so would mean that the other prices would need to be higher in compensation.

But we are very sensitive to unfairness — even if it is perceived rather than real. We resist being taken advantage of. We don’t care that there are good economic arguments for surge pricing — we think it is not just unfair, but unethical and unconstitutional.

But we can be a bit selective with our insistence on fairness. We may be happy to demand from businesses that they take a financial hit to treat us and others more fairly, but if it is within our own power to do so, we seem less keen to put our money where our mouth is. For example, the proportion of fair-trade coffee sold in the UK is 20% (just 4% for instant coffee). At the same time, we seem pretty content with dearer train tickets at peak times, and with having to pay more for a cinema ticket on a Saturday night than on a Tuesday afternoon or for a holiday during the school breaks.

How much for that mark?

Maybe the conflict between the real world with our messy emotions and that of economic theory, where only the logic of resource allocation counts, is largely a matter of perception. Loss aversion would explain a lot. Having to pay more for something that we see as the same version of a cheaper option feels as an unjustifiable loss.

If that is the case, it is remarkable indeed that suppliers are not always and everywhere framing the highest prices as the standard, and the lower prices as discounts. A nice story shows how reframing a price when people think they’re being taken for a ride can make them change their perception:

True, myth busting site Snopes considers it a legend, but legends often contain important and enduring lessons. Maybe, with the right framing, we may yet see the fairness in market transactions.

Originally published at koenfucius.wordpress.com on July 7, 2017.

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Accidental behavioural economist in search of wisdom. Uses insights from (behavioural) economics in organization development. On Twitter as @koenfucius