Questionnaire studies show that perceptions of fairness cause people to resist price increases following abrupt changes in conditions with no cost justification. We examine this hypothesis in posted-offer markets extending previous work. Consistent with the hypothesis, in the profit disclosure (fairness) treatment prices are initially below those in the cost and the no disclosure treatments. Over time prices converge in all treatments to the competitive surplus maximizing equilibrium. Fairness is thus interpreted as being a result of expectations that are not sustainable. Expectations adapt as the market converges to the predicted competitive equilibrium.

Praveen Kujal

Vernon L. Smith

English

Research Papers in Economics

 
 
 
 
 
 
Working Paper 03-60 
Economics Series 24 
November 2003 
 
 
Departamento de Economía 
Universidad Carlos III de Madrid 
Calle Madrid, 126 
28903 Getafe (Spain) 
Fax (34) 91 624 98 75 
 
 
 
 
 
FAIRNESS AND SHORT RUN PRICE ADJUSTMENT IN POSTED OFFER MARKETS * 
 
 
Praveen Kujal
1 and Vernon L. Smith
 2 
 
Abstract 
Questionnaire studies show that perceptions of fairness cause people to resist price increases 
following abrupt changes in conditions with no cost justification. We examine this hypothesis in 
posted-offer markets extending previous work. Consistent with the hypothesis, in the profit 
disclosure (fairness)  treatment prices are initially below those in the cost and the no disclosure 
treatments. Over time prices converge in all treatments to the competitive surplus maximizing 
equilibrium. Fairness is thus interpreted as being a result of expectations that are not sustainable. 
Expectations adapt as the market converges to the predicted competitive equilibrium. 
 
 
 
 
Keywords: Fairness, price convergence, posted-offer.
 
 
 
 
 
1 Departamento de Economía, Universidad Carlos III de Madrid. E.mail: kujal@eco.uc3m.es. Telf..: 
(34) 91 624 9651 
2 Department of Economics and ICES, George Mason University, 4400 University Drive MSN1B2, 
Fairfax, VA 22030, email: vsmith2@gmu.edu. 
 
* Prepared for the Handbook of Results in Experimental Economics. 
 
 
 
 
 Fairness and Short Run Price Adjustment in Posted Offer Markets 
 
Praveen Kujal, Universidad Carlos III de Madrid 
Vernon L. Smith, George Mason University 
 
 
Introduction 
In the context of pricing in retail markets, using questionnaire survey studies, Kahneman 
et. al. (1986a, hereafter KKT; 1986b) indicate that fairness norms imply that any change in price 
in the short run that is not justified by a cost increase is unfair.  Moreover, they argue that many 
people would follow fair policies in the absence of enforcement through punishment. They 
further argue that this kind of (fair) behavior may imply that markets may not clear if excess 
demand is not justified by an increase in supply costs (KKT, p. 213). This is due to the “principle 
of dual entitlements” where customers have a right to the terms of a reference transaction, while 
the firm has a right to a reference profit (Zajac, 1985, pp. 139-141), implying that recent posted 
prices may serve to define the reference transaction. 
  Fairness in KKT can be interpreted as an adaptation; i.e. any persistent state of affairs 
over some period of time may be accepted as fair.  Thus a given state may come to be accepted as 
a reference transaction that may form the benchmark in evaluating any future changes. An 
implication of these considerations could be the following:   the short-run price response to 
situations of excess demand may be sluggish if a price increase is not justified by an increase in 
unit supply cost. However, if excess demand persists, only higher new prices would be 
sustainable, and people will adapt by redefining the reference transaction.  As we interpret it, the 
equilibrium may still be what is predicted from economic theory in the absence of a utility payoff 
from fairness.   In this paper we hypothesize that any short-run failure of markets to clear depends upon 
buyers knowing that increased profits result from higher prices. In the absence of this knowledge 
buyers may give in quickly to the equilibrating tendencies of the market. 
Market Experiments 
  Kachelmeier et. al. (1991a, hereafter KLS) report laboratory experiments designed to 
measure the effect of fairness considerations on actual price responses and convergence behavior 
in experimental markets using  buyer posted bid pricing. In their experiments five buyers and five 
sellers trade for 10 periods under stationary value/cost conditions. Buyers independently post bid 
prices and sellers respond with individual sales by accepting bids. Then a change is introduced 
for a new ten period sequence. In the first sequence the sellers are subject to a 50% profit tax 
such that, at the competitive equilibrium price and volume, the seller’s share of  total surplus is 
exactly 50%.  In the second stage (10 periods), the profit tax is replaced by a 20% sales tax on 
each seller’s revenue. The effect of this is to raise the previous marginal cost, MC(q), to 
1.25*MC(q). This raises the competitive equilibrium price, lowers the volume, and increases the 
seller’s share of the total profit with respect to the earlier design.  They replicate each of the 
different information treatment three times with different subjects (90 subjects total): 
  (1) seller marginal cost information is disclosed to all the subjects: with the sales tax 
buyers are informed that prices must increase to cover the new seller costs. 
  (2) seller’s share of aggregate profit is disclosed to all the subjects: with profit disclosure 
buyers are fully informed, compared with the previous ten reference transaction periods, that the 
change to a sales tax regime has shifted net surplus from buyers to sellers. 
  (3) no marginal cost or profit information is disclosed. 
  Information revelation in those treatments corresponds to the KKT conjectures that:   (a) under profit revelation as sellers are only entitled to their previous reference profit it 
would be ‘unfair’ for the sellers to profit from the tax and, 
  (b) with the marginal cost disclosure any price increase would be justified by a unit cost 
increase. Treatment (1) with no marginal cost or profit disclosure provides experimental control. 
These experiments generate the following prediction hypotheses (based on KKT and KLS , p. 
697). 
  H1:  price response to changing from an income to a sales tax will be greater under 
  marginal cost disclosure than under profit disclosure. 
  H2:  faster under marginal cost disclosure. 
  H3:  slower under profit disclosure. 
KLS report statistical support for all three hypothesis. 
Extension: Posted Bid vs. Posted Offer 
  The institution used by KLS is posted bid pricing. They defend this on the ground that as 
the preliminary interest is to look at fairness perceptions and responses of buyers an institution 
where buyer responses are directly measurable is suitable (KLS, p. 700). 
  We examined the robustness of the KLS results using the Posted Offer retail institution 
(Ketcham, Smith and Williams, 1984).  Primarily this is the institution that KKT have in mind in 
their consumer market examples (although they do discuss implications for labor markets where 
wage bids are made by the firm). KKT talk of retail incentives to behave fairly (KKT, p.212) if 
consumer response to ‘unfair’ pricing would be to switch firms.  If the firms anticipate this, they 
will have an incentive to price fairly. As a result, in the Posted-Offer market institution we can 
study the tendency of firms to price fairly and of buyers to punish firms that depart from fair 
pricing.   In our experiments sellers could not see each others prices. This was done so as to reduce 
seller undercutting and thus separate lower prices due to competition from lower prices due to 
fairness. This was intended to give the KKT hypothesis its best shot. 
Our Experiments: 
  We used essentially the same parameter configurations and information disclosure 
treatments as did KLS.  Our design differed in the following respects. 
  1. We used six buyers and sellers rather than five each. 
  2. Each treatment was replicated four times instead of three times. 
  3. Our experiment length varied. In stage 1 the control experiment was run for twelve 
periods while the marginal cost and profit disclosure experiments were run for ten periods each. 
In stage 2 the profit disclosure experiments were run for twenty periods while the others were run 
for ten periods each. The longer profit disclosure experiment enables us to determine whether 
equilibrating tendencies continued after the first ten periods. 
  4. Between stage 1 and stage 2, KLS scheduled a break allowing buyers and sellers to be 
separated (ostensibly to pay them privately) and given the required separate instructions for stage 
2, sales tax (no disclosure), regime. We simply chose to pass out different instruction forms to 
buyers than to sellers in the control experiment; since everyone received handouts this disguised 
the different treatment of sellers. The instructions to buyers informed them that their redemption 
value in stage 2 were the same as in stage 1, while it explained to the sellers that starting in the 
next period they would pay a sales rather than a profits tax. 
  The subjects earned non-trivial amounts of money. Payoffs for the experiments ranged 
from $8.75 to $62.50. 
Hypothesis and Experimental Results We examine the following hypothesis (see Franciosi, et al., 1995 for formal hypothesis tests): 
  H1: In stage 2, the first period of trading under the sales tax regime, the KKT fairness 
argument will yield prices ordered as follows: 
  Prices (marginal cost disclosure)>Prices (no disclosure)>Prices (profit disclosure). 
  H2: By period 10, stage 2, the prices under the various treatment conditions will be 
indistinguishable. 
  H3: Under the profit disclosure treatment, the two experiments that continue for twenty 
periods in stage 2 will show convergence to the competitive equilibrium. 
<figure-1 here> 
 
  Looking at figure 1, it is clear that in stage 2  initially there is a clear separation of mean 
observed prices in accordance with H1. Under the marginal cost disclosure treatment, plotted in 
green, the mean price jumps immediately to the competitive equilibrium, while under profit 
disclosure, plotted in red, the price does not change from its earlier ‘reference’ transaction level. 
With no disclosure, plotted in blue, the mean price is above that for profit disclosure, and below 
the mean for marginal cost disclosure.  By period ten mean prices under all three information 
conditions have converged to near the competitive equilibrium ($2.90). Finally, the two profit 
disclosure treatments that were run for twenty periods yield mean prices that stabilize near the 
competitive equilibrium. 
  It is clear that the profit disclosure treatment has slower price convergence than the other 
treatments.  Further, in the early parts of stage 2, profit disclosure softens the profit seeking 
behavior of the sellers relative to the other experiments. However, prices under the control and 
the marginal cost disclosure treatments are indistinguishable after the first three periods in stage 
2.   Another consequence of the KKT hypothesis was that buyers, upon seeing unfair prices, 
may choose punishing strategies.  In our experiments this, would be manifest by buyer 
withholding. Withholding occurs if a buyer fails to purchase a unit of a good that is offered for 
sale at a price less than the buyer redemption value. The incidence of withholding in the profit 
disclosure treatment (23 units) was much greater than in the sales tax treatment (4 units), 
however, 22 of the cases were from one experiment in the profit disclosure treatment!  Note that 
this observed withholding was an uncontrolled treatment variable and that mean prices in the 
experiment with the high withholding were not higher than in the other experiments with the 
sales tax.  In our experiments withholding did not manifest itself in the form of lower efficiencies 
as mostly marginal units were withheld. 
Discussion 
  Experimental work such as ours and that of KLS has studied the effect of alternative 
information disclosures on the prices posted by a seller subsequent to an exogenous shift in seller 
marginal costs (a sales tax).  If buyers will resist any price increase that is not cost justified then, 
recognizing this, sellers will post lower prices under profit disclosure than under marginal cost 
disclosure. However, these lower prices need not persist over time if fair prices result in 
situations of excess demand. That is, equilibrium behavior may allow the establishment of new 
reference transactions that will prevail in the long run. Our results support this interpretation of 
fairness. Consequently, the prediction that equilibrium outcomes will reflect the rational behavior 
of standard economic models is supported. However, the transition path to a new equilibrium is 
be affected by ‘fairness’ considerations. 
What is Fairness?   In the context in which we study fairness it is clear that self-interested maximizing 
behavior dominates disequilibrium fair prices in the long run.  This implies that fairness 
considerations do not belong in the utility function as an externality that alters equilibrium 
behavior in a sustainable way as predicted by the own utility maximizing model. 
  We suggest that ‘fairness’ in our context is best characterized as affecting agent 
expectations and not their utility functions. (Also see Binmore et al., 1992).  That is, buyers feel 
that price increases resulting from cost increases ‘should not’ produce higher profits for sellers. 
Sellers, accepting this norm of fair treatment do not, initially, attempt to raise prices and extract 
higher profit. In the absence of obtaining utility from being ‘fair,’ over time sellers gradually 
raise prices and reap higher profits. This adaptation to a higher price takes place due to the 
competitive behavior of both buyers and sellers. Some buyers realize that there are gains (higher 
consumer surplus) from trade from buying at slightly higher prices. Sellers on the other hand are 
able to subsequently charge higher prices as buyers battle for gains in surplus from the marginal 
units. Thus, what alters over time, and adapts as a social norm, are the expectations of the buyers 
and sellers as to what is fair. This also explains why fairness dominates the KKT questionnaire 
response of subjects. Their answers are based upon their expectations, not on the unanticipated 
adjustments that can occur along a convergence path. This happens because the market 
participants do not know, and can not anticipate the new equilibrium and its possible effect on 
what is fair. 
  Finally, questionnaire data summarizes average and not marginal opinion, while 
competitive outcomes are driven by marginal analysis. In markets like ours, as was reflected in 
buyer behavior, the gains from trade on the marginal units determined the eventual transition to the market equilibrium. Eventually, self maximizing behavior dominates, overcoming the initial 
resistance based on what is thought to be fair prices. References 
Binmore, K., Swierzbinski, Hsu, S., and Proulx, C. (1993), “Focal points and bargaining,” 
International Journal of Game Theory, (22) 4, pp. 381-409. 
Franciosi, R., Kujal, P., Michelitsch, R., Smith, V., and Deng, G. (1995), “Fairness:  effect on 
temporary and equilibrium prices in posted-offer markets,” The Economic Journal, vol. 
105, no. 431(July), pp. 938-950. 
Kachelmeir, S., Limberg, S., and Schadewald, M. (1991a), “A laboratory market examination of 
the consumer price response to information about producers’ cost and profits,” The 
Accounting Review, vol. 66, no. 4 (October), pp. 694-717. 
Kachelmeir, S., Limberg, S., and Schadewald, M. (1991b), “Fairness in markets: A laboratory 
examination,” Journal of Economic Psychology, vol. 12 (September), pp. 447-64. 
Kahneman, D., Knetsch, J., and Thaler, R. (1986a), “Fairness as a constraint on profit seeking: 
Entitlements in the market,” American Economic Review, vol. 76   (September), 
reprinted in R. Thaler, Quasi Rational Economics, Russell Sage Foundation, New York 
1991, pp. 199-219. 
Kahneman, D., Knetsch, J., and Thaler, R. (1986b), “Fairness and the assumptions of  
economics,” Journal of Business, vol. 59. part 2, reprinted in R. Thaler, Quasi Rational 
Economics, Russell Sage Foundation, New York 1991, pp. 199-219. 
Ketcham, J., Smith, V. and Williams, A. (1984), “A comparison of posted offer and double 
auction pricing institutions,” Review of Economic Studies, vol. 51   (October), pp. 595-
614. Zajac, E. (1985a),  “Perceived economic justice: The example of public utility regulation,” in H. 
P. Young ed., Cost Allocation: Methods, Principles and Applications, Amsterdam: 
North-Holland.Figure 1:  The experiments use 6 buyers and 6 sellers in the posted-offer trading institution.  
Each of the two treatments, Stage 1 and Stage 2, were replicated 4 times.  In stage 1 two control 
experiments with no cost or profit disclosure, were run for 12 price/purchase periods; the others, 
marginal cost and profit disclosure, were run for 10 periods. In stage 2 two profit disclosure 
experiments were run for 20; the others, marginal cost and control, for 10 periods. 
  In the profit disclosure experiments all subjects were informed about the aggregate profits 
of the sellers. Further, after the imposition of the sales tax they were informed that sellers’ share 
of total surplus has now increased. In the marginal cost disclosure treatment seller marginal cost 
was disclosed to all the subjects. In stage 2 buyers were also informed that prices will have to 
increase to cover the new (increased) seller costs. 
  In stage 1 Sellers pay a 50% profit tax such that, at the competitive equilibrium they have 
exactly 50% of the net surplus.  In stage 2 Sellers pay a 20% sales tax that raises their marginal 
cost schedule. The sales tax increases the competitive equilibrium price, lowers the volume and 
increases the sellers’ share of the total profits.  In the no disclosure treatment, sellers were 
informed privately that in stage 2 they will pay a sales tax rather than a profit tax.  The buyers 
were simply informed that their redemption values will stay the same. 
  Mean prices for no disclosure are plotted in blue, for marginal cost disclosure in green, 
and for profit disclosure in red.  In stage 2, as hypothesized, the mean price is highest under 
marginal cost disclosure, next highest under no disclosure and lowest under profit disclosure.  
But over time, we observe convergence to the competitive equilibrium in all treatments, by 
period 10.  Moreover, under profit disclosure the price hovers near the competitive equilibrium in 
periods 11-20.  Conclusion:  fairness considerations effect initial prices as expected, but over 
time prices reflect the underlying supply and demand conditions. Figure 1
2.5
2.6
2.7
2.8
2.9
3
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
period
p
r
i
c
e
no disclosure
marginal cost disclosure
profit disclosure
Stage 1: Profit Tax Stage 2: Sales Tax
competitive
equilibrium (sales tax)
competitive
equilibrium (profit tax)
There was some evidence of 
witholding in one experiment of 
the profit disclosure treatment. In 
the sales tax regime, in this 
experiment, there were 22 cases 
of witholding compared to only 4 
cases in the profit tax regime. 
Witholding occured inspite of the 
prices being lower in this 
experiment.
Price in the profit disclosure experiments are the 
lowest. Convergence starts below the other two 
treatments and is slower in both the stages. 
However, by the period 11 prices converge to the 
competitive equilibrium.
Price convergence in the       
marginal cost disclosure 
experiments is immediate and is 
indistinguishable from the no 
disclosure experiments.
Prices between these two 
treatments are indistinguishable.

A comparison of posted offer and double auction pricing institutions,”

A laboratory market examination of the consumer price response to information about producers’ cost and profits,” The Accounting Review,

Fairness and the assumptions of economics,”

Fairness as a constraint on profit seeking: Entitlements in the market,”

Fairness in markets: A laboratory examination,”

Fairness: effect on temporary and equilibrium prices in posted-offer markets,”

Focal points and bargaining,”

FAIRNESS AND SHORT RUN PRICE ADJUSTMENT IN POSTED OFFER MARKETS

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FAIRNESS AND SHORT RUN PRICE ADJUSTMENT IN POSTED OFFER MARKETS

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