Fairness matters in life. People are motivated to achieve fair outcomes. (Although people are generally quicker to notice shares that are unfair to them than to other people.) Given business is a human social endeavour it shouldn’t be a huge surprise that fairness matters in business too. Adding fairness concerns to models of how business works is tricky, fairness can be challenging to define, but it is possible to use simple notions that capture the genial idea.
Tony Cui, Jagmohan Ragu and John Zhang capture fairness concerns in business to business pricing, e.g. how a manufacturer prices the goods that they sell to a retailer. (FYI Tony served on my dissertation committee.) They model fairness by specifying a fair relationship between the manufacturer’s and retailer’s profits, e.g. fifty:fifty. Deviations from this fair share upset the retailer. That said deviations that give the retailer relatively more profit are less upsetting to the retailer than those which give the retailer relatively less. The manufacturer knows that the retailer cares about fairness when setting the price to charge the retailer.
The authors use fairness concerns to shed light on a puzzle in business. Why are channel pricing contracts relatively simple? There are a number of possible reasons but “… the simplicity of channel contracts may also be due to “a richer real-world environment” where channel members care about fairness in their transactions” (Cui, Raju and Zhang 2007, page 1304).
A major problem in channels is double marginalization. Prices are set higher than the level to maximize channel profits as the retailer and manufacturer both try to maximize their own profit without thought to what works best for them as a team. This is bad for everyone; less is sold than would be at a lower price, those customers who do buy pay more than they should and the channel (as a whole) makes less profit. The solution to this can involve complex pricing schemes set up by the manufacturer to incent the retailer to charge the “right” price. The authors show that a concern for fairness on the part of the retailer can make things a lot easier, meaning a simpler pricing scheme will do.
It is interesting to see how the authors link two observations, the existence of fairness concerns and simple pricing schemes. Work such as this explains how tweaking our assumptions about how people behave can help make our theory much more applicable to the real-world.
Read: Tony Cui, Jagmohan S. Raju and Z. John Zhang, 2007, Fairness and Channel Coordination, Management Science, Vol 53, Issue 8, Pages 1303-1314.