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By Sally Blount-Lyon
CONTRARY
TO POPULAR BELIEF,
Yet, many smart people have fallen prey to this belief. For the past two years, John Jost of Stanford University and I have conducted research on peoples’ attitudes toward markets. Our conclusion: many intelligent people are prone to the “fair market illusion.” That is, they have tended to believe – incorrectly – that market outcomes are inherently fair and that the market process of determining how resources are allocated is a fair one. What Is Fairness? Of course, the concept of fairness is quite complex. Psychologically, the idea emanates from social comparison processes – our tendency to compare ourselves with our people – and the need for control and predictability in life. As psychologist Melvin Lerner demonstrated in the 1960s, people have a need to believe that life is controllable, and that life’s outcomes are fair. But life isn’t “fair.” People’s life circumstances are quite diverse and subject to chance events. Thus considered, any sense that fairness exists at all is an illusion – albeit a widespread one! As a consequence, social psychologists have spent a considerable amount of energy over the last 20 years trying better to understand the nature of our fairness illusions. In the process, psychologists have identified three types of fairness judgments that people tend make: outcome, procedural, and process. Regarding outcomes, fairness can be thought of as a judgment that people make regarding the acceptable degree of equality (or inequality) across parties’ payoffs in particular situations. As an example, people often think of even splits as fair. Psychologist Morton Deutsch has identified three types of outcome fairness that people tend to make: based on equality, equity (in proportion to earned rights or inputs), and need (given first to those in need). As he found, equality norms are most prevalent in friendships – i.e., we generally split restaurant bills evenly. Equity norms, by contrast, are more common in business relationships. People generally find it fair that those who invest more receive a greater share of returns. Fairness judgments are also often made regarding the procedures used to generate outcomes, particularly when it may not be possible to achieve outcome fairness. Procedural fairness norms help organize expectations about how scarce resources will be distributed across many people. For example, people often perceive that flipping a coin is a fair way to determine between two people who will get a one-of-a-kind item. Lotteries, first-come-first-served lines, and rationing are also commonly accepted fair procedures. Psychologist Gerald Leventhal has identified several characteristics commonly associated with fair procedures. These include consistency across people, being based on accurate information, correctable in the case of error, structured to suppress bias, and reflecting prevailing ethical norms. People also apply fairness judgments to evaluate how social interactions unfold – i.e. the process. In social interactions, people like to feel respected and that their needs have been given adequate consideration. When this does not happen, people say that they were unfairly treated. Applying Fairness to Markets Understanding fairness perceptions in markets is especially challenging, because some aspects of markets appear “fair,” and others do not. For example, one of the fair aspects of markets is that they allow everyone equal access. Theoretically, anyone can participate, regardless of gender, race, or background. On the other hand, because the way people participate in markets is through economic currency, markets seem to have an unfair income bias. Because buyers who have more money can afford to pay more for goods, they tend to get more in a market system. It is this income bias that motivates governments to prohibit certain goods, such as donor organs, from being allocated through markets.
Sometimes, instead of saying that markets are fair, people use the term “fair market price.” Here, market price typically refers to available information about what other people have recently paid for a similar good or service, or the price at which other sellers are offering a similar item. In thick markets – such as soda or personal computers – prices vary little, and it is relatively easy to identify what is perceived as a prevailing market price. In thin markets, where pricing is more variable, such as fine art or nuclear fuel, identifying a prevailing market price is more difficult. Many people characterize a prevailing market price as the “fair market price.” While that price may intuitively “feel” good, there is nothing particularly fair about it. Yes, it does represent a market clearing price – that is, a price at which many buyers and sellers are willing to exchange. But there is nothing inherently just about that point. In theoretical terms, it simply represents a point in two-dimensional, price-quality space where the two abstract lines (supply and demand) cross. While that point is efficient, no economist worth his or her degree would ever claim that that point is intrinsically fair. Consider, for example, an unregulated monopoly. There may be a well-defined market price, but the seller typically garners most of the surplus. Is that fair? Probably not, and that’s why governments often seek to regulate monopolies. Besides, supply and demand curves don’t explicitly exist in real life. No one ever gets all of the buyers and all of the sellers in a market together at the same time to ask them (a) how many units they each want to buy or sell, and (b) what the maximum (or minimum) price is that they are willing to accept. Further, no one then takes that information and aligns all of these prices in descending order (for buyers) and ascending order (for sellers) to see where these two plots intersect. The supply-demand framework is a theoretical model that captures some important nuances about markets – but it is not what real life looks like. And by and large, it is not how markets actually work. In the end, our research suggests that, to the extent that fairness is assumed in markets, it has more to do with procedural fairness than with outcome or process fairness. Transacting at the prevailing market price feels good, because you feel you are being treated in a just manner. Enacting a market price-based transaction implies a procedure that is consistent across bargainers, free of bias, based on data that is representative and relevant, and is culturally appropriate. Biased Judgements? Interestingly, there is substantial research that finds that the degree to which people associate market outcomes with fairness may be subject to cognitive biases and contextual framing. For example, it has been found that people typically perceive that market outcomes are more fair when they result in wage increases than wage decreases. In addition, market outcomes are considered more fair when they lead to sudden decreases in buying prices rather than sudden increases. In addition, there is a status quo bias at work. Situations that don’t change feel more fair than situations that do. Prices that do not change, or change only slightly, are usually perceived as most fair. Research also finds that people tend to favor the fairness norms that favor their own interests. In market contexts, this tendency has at least two implications. First, when market outcomes favor one party over another, the party who benefits is more likely to use the “markets-are-fair” rationalization to justify the outcome. The more advantaged party is more likely to rationalize his comparative win, because “everyone agrees that markets are fair.” Second, this tendency means that in thin market contexts – those in which pricing is perceived to vary – people tend to selectively anchor on “comparables” that favor their own position and believe in the inherent fairness of that information as a reasonable reference point for resolving the situation. In a clever paper studying teacher contract negotiations, Linda Babcock and her colleagues at Carnegie Mellon University presented data that vividly demonstrates this bias. Specifically, they found that mean teacher salaries in school districts that unions view as being comparable to their own tend to be significantly higher than mean teacher salaries in districts that school boards view as being comparable to their own. Babcock and colleagues also found that strike activity is positively correlated with the size of the difference between the comparables that a union and school board bring to the table.
Research that I have conducted with Margaret Neale of Stanford University and Melissa Thomas-Hunt of Cornell University shows that in thick market contexts, the fair market illusion often leads people to overweight the validity of market-based data. We told negotiators in our research laboratory that they were negotiating the hypothetical sale of either an antique carousel horse or a new stereo. We told them how much they could afford to spend, and what they thought the item was worth. They were also given common information about the price at which a single, similar transaction had recently closed. When negotiating for the antique, the bargainers were much less influenced by the single piece of market data than when they were when negotiating for the stereo. People assumed that stereos are more commodity-like, and bargainers in both roles mistakenly used the market data as a proxy for market price. They assumed that it was the “right” and “fair” way to resolve the negotiation – even though it represented only one other recent trade. In the stereo context, both buyers and sellers fell prey to the fair market illusion to a degree that overweighted the available market data in setting price. To examine the fair market illusion more deeply, my colleague John Jost and I have been collecting survey data from undergraduate students, MBA students, and executives at Stanford University, the University of Chicago, and New York University for the last two years. And we have found the “fair market illusion” to be rampant among people well-educated in economics. For example, the average MBA student is likely to agree just as strongly with the statement, “The free market system is a fair system,” as with the statement, “The free market system is an efficient system.” Training in economic courses does not seem to improve the correctness of these answers between the first and second years. We did, however, find that within these populations, some people are more prone to the belief than are others. For example, we have found that the degree to which people fall prey to the fair market illusion is strongly correlated with the degree to which people report being politically conservative rather than liberal. It is also strongly correlated with espoused beliefs that hierarchies are natural and social inequality is inevitable. Together all these findings have two important implications. First, they suggest that many people trained in business schools are leaving with an incorrect understanding of what markets are and what markets aren’t. Markets are about creating wealth and allocating resources efficiently – not necessarily intelligently or compassionately. Markets are not intrinsically just, intelligent, or moral. Free trade can not by itself make sure that the poor get fed, the best ideas receive funding, and the world becomes a qualitatively better place. Further, when people believe that markets are fair, they are prone to systematic processing errors and bandwagon effects. The fair market illusion leads people to overweight readily available market data when making financial decisions and become overconfident of their decisions. This tendency lends some insight into the inflated stock market valuations from two years ago. While many stocks were trading at particularly high prices, those prices were clearly not sensible or intelligent, and certainly not “fair.” Sally Blount-Lyon is professor of management at NYU Stern. |
ntil
recently, most business people possessed a bedrock of faith in the
efficiency, power, and fairness of markets. And a great deal of it
was justified. When trade occurs freely, the maximum amount of wealth
is created for the largest number of people. There is no more effective
social system for organizing people and allocating resources than
markets. But while markets are efficient, there’s nothing inherently
fair about them.
