UABS KNOWLEDGE

ECONOMICS

Why poor pricing decisions tarnish brands

17 May 2016

Notions of fairness matter for a variety of economic transactions, argues Ananish Chaudhuri.

Remember when Adidas jacked up the price of All Black jerseys just before the 2011 Rugby World Cup? And the outrage when it moved to block attempts by local team supporters to order cheaper jerseys online from overseas suppliers? Emotion ran so high that even the prime minister weighed in on the debate, and several local retailers showed solidarity by doing the unthinkable – selling the jerseys at a loss.

So what went wrong for Adidas? After all, the company had merely followed the age-old practice of price discrimination – charging more to buyers who had little price flexibility, in the expectation that they would be willing to pay a premium.

Writing in the latest issue of the University of Auckland Business Review, Professor Ananish Chaudhuri, of the Business School's Department of Economics, says it comes down to ideas of fairness.

"The logic behind such pricing strategies depends crucially on people's willingness to accept the price. If enough people consider it to be unfair and refuse to buy then the anticipated profitable trades no longer take place," he says.

"The idea that notions of fairness may matter for a variety of economic transactions, including pricing, is not usually taught in classrooms or adequately appreciated by businesses. But there is mounting evidence that they do."

That evidence comes in the form of economic decision-making experiments using real money. One, called the Ultimatum Game, involves recruiting a number of strangers and splitting them equally into two groups which are then placed in separate rooms. One group, the 'proposers', are each given $10 and told to split the money with an unknown and unseen 'responder'. The proposer could, for example, keep $8 and offer $2. If the responder accepts, then both get the designated amount. If the offer is refused, neither get anything. Logically, the proposer should make a low offer – say $1 – and the responder should accept, because it is better than nothing.

"However, it turns out that over many replications of the game in a variety of countries proposers almost always made more generous offers – in the range of $4 to $5 – and offers of less than $3 were routinely turned down by responders," says Professor Chaudhuri.

To overcome objections that the outcome was due to the small sums involved, the game was repeated in Indonesia using stakes equivalent to a month's wage or more, and in the US where college students played with stakes as high as US$100. Surprisingly, these experiments produced offers that were even more equitable.

More elaborate games were then devised to test whether, in turning down small offers, responders were reacting to the amount involved or protesting against the unfairness of the offer – in other words, whether they were objecting to the 'intentions' of the proposer. And second, to discover whether large offers were made in anticipation of small offers being rejected, or merely out of generosity.

The first question was answered by introducing computers into the game. Computer offers, no matter how small, were inevitably accepted whereas unfair human offers were almost always refused. To settle the second question, the ability of the responder to punish the proposer was removed. Investigators found that in situations where rejection of an offer didn't affect how much the proposer received, they always made small offers.

In addition, extensive surveys on attitudes to company behaviour have found that many actions that are profitable in the short-term and not obviously dishonest are nevertheless widely considered to be abuses of market power.

But does fairness make a difference in the real world? Adidas' experience suggests that it does. Chaudhuri ends with another actual case where the stakes were high: the strike of US major league baseball players in 1994, which led to the cancellation of 938 games. Team owners wanted a cap on player salaries and proposed a revenue-sharing plan. The players' union rejected the offer and prolonged negotiations failed to break the impasse.

"The players essentially walked away from US$230 million collectively – the average salary of players at this time was about US$1.2 million per year – because of what they considered was an unfair offer. This in turn resulted in a loss of more than twice that amount for the owners."

Read Is the Price Right: fair play and economics, in the University of Auckland Business Review

Ananish Chaudhuri

Professor Ananish Chaudhuri is Head of the Department of Economics at the University of Auckland Business School.

a.chaudhuri@auckland.ac.nz

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