In my previous post I wrote about the fairness of drug companies that dramatically increase the price of their products. I suggested, and public reaction confirmed, that these price increases are considered unfair.
When is a price increase fair? When is it unfair?
The economic principle of profit maximization tells us that firms ought to increase prices when there is an increase in demand or a decrease in supply, regardless of whether the change is short-term or permanent. So if a hurricane is closing in on the East coast of the U.S., then suppliers of lumber, bottled water, gasoline and other supplies that people will need should and will increase the prices of these things … a lot. But is that fair?
Daniel Kahneman, Jack L. Knetsch and Richard Thaler published a paper on this topic 30 years ago in the American Economic Review. They argued that people’s perceptions of fairness will (or ought to) constrain impulses to take advantage of short-run increases in demand or other reasons to increase prices, under certain conditions.
Their discussion entails two elements. One has to do with reference points and the other has to do with reasons for gaining at the expense of others.
First, a reference point is the basis upon which people create expectations about the fairness of a transaction or a change in prices. If transactions or price changes are consistent with the reference point, then people will judge the transactions or price changes as fair. In other words, reference transactions and reference profits are considered fair. If there is a deviation from the reference point, then assessments of fairness will be made based on whether good reasons exist for the deviations.
The authors define the reference points as follows:
Market prices, posted prices, and the history of previous transactions between a firm and a transactor can serve as reference transactions. When there is a history of similar transaction between firm and transactor, the most recent price, wage, or rent will be adopted for reference unless the terms of the previous transaction were explicitly temporary. For new transactions, prevailing competitive prices or wages provide the natural reference.
For example, if a gas station has been selling gas for $1.99 a gallon for several weeks, then the reference price is $1.99 a gallon, and people will expect that to be the price the next time they get gas. If the price of gasoline increases, say to $2.09 a gallon, then people will likely consider the price increase unfair unless they understand there to be a good reason for the change. Good reasons have reference points, too. For example, raising prices at the expected rate of inflation is not considered unfair, since inflation-based price increases can be a reference point. We have historical experience with that, so there is no basis for claiming unfairness. The same about price changes in gasoline. If the reference point for price changes is 5 cents a gallon, then people won’t be bothered by finding the price of gasoline is higher by 5 cents the next time they buy gas. But if prices increase by more than 5 cents, then they might believe or expect something unfair is happening at their expense.
Understanding reference points for transactions, pricing and profits can help us understand why unfairness might be claimed when businesses increase prices. For example, if employees had previous experiences of getting pay increases when competitors raised their employees’ wages, then a reference point is created for employees. But if the employer has not historically increased wages when their competitors have, then the reference point for the employer will differ from that of the employees, resulting in disagreements about fairness.
Second, an important principle of fairness is that one should not gain by imposing a cost or harm on others.
Raising the price of lumber, bottled water, gasoline and other supplies that people will need when a hurricane is imminent can be considered imposing a harm on others to acquire a short-term gain. It doesn’t matter that economics dictates that price increases are needed to resolve shortages that will arise when there is a sudden increase in demand. There is usually no viable reference point for such behavior.
Raising prices because a business experiences an increase in costs is different. Such behavior is not considered as imposing a harm on others merely to benefit at their expense. Businesses are not gaining substantially, if at all, when they increase prices to cover their rising costs.
The implication is that people are willing to accept as fair an increase in price to cover rising costs. They also consider it fair for businesses to maintain prices when costs decline. But people consider raising prices when demand increases or without explanation or justification to be unfair.
Most people have no reference point for drug prices rising 5000 percent or even 500 percent. Such behavior is very unfair.