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If you have watched The Apprentice, you’ve seen an all-too-common view of business: the wannabe moguls try to impress Donald Trump (or Tokyo Sexwale, in the South African chapter of the series) by preening, cajoling and conniving.

March 27, 2008

If you have watched The Apprentice, you’ve seen an all-too-common view of business: the wannabe moguls try to impress Donald Trump (or Tokyo Sexwale, in the South African chapter of the series) by preening, cajoling and conniving.

But according to John Zhang and Jagmohan Raju, both marketing professors at the Wharton School of the University of Pennsylvania; and Tony Haitao Cui, a University of Minnesota marketing and logistics professor, many people aren’t purely mercenary in their business dealings. They care about fairness – and so they should, the researchers say, because doing so can maximise their profits.

A manufacturer and a retailer can both make more money if they are fair minded, setting prices with an eye to achieving an equitable outcome in their joint marketing channel, as opposed to merely maximising their individual profits, according to Zhang, Raju and Cui.

When people are fair minded, they don’t need to enter into complicated contracts to co-ordinate their marketing channels and maximise profitability. “A constant wholesale price will do,” say the professors. “When a fair channel is co-ordinated through a constant wholesale price, the retailer perceives no inequity. Therefore, a constant wholesale price … can help to foster an equitable channel relationship.”

Call it a new glove for the Invisible hand: the manufacturer sets a price, and the retailer’s sense of fairness takes care of the rest.

When the retailer sees that he is being treated fairly by the manufacturer, he will reciprocate by picking a retail price that rewards the manufacturer. Because each gets an equitable share of the channel’s profit, they won’t squabble. “If you are fighting against each other, ultimately the whole channel will suffer,” Zhang notes.

Conventional wisdom says that the manufacturer must enter into an elaborate contract with the retailer to align their interests. “In practice, you rarely see that,” Zhang says. “You mostly see a simple wholesale price contract … What we show is that, as a retailer, you care about fairness; you want to be treated nicely, and you’ll treat me nicely if I treat you that way.”

For this kind of co-ordination to work, the retailer has to be able to ascertain the manufacturer’s costs. Otherwise, he can’t gauge the fairness of the wholesale price. “With transparency, it works better,” Zhang says. “You would know what’s fair and what’s not.”

Transparency isn’t a difficult condition to satisfy. Retailers typically have access to information on their suppliers’ costs – for instance, “when the manufacturer supplies a standardised product or a commodity”, the scholars write. “In that case, competitive offers from manufacturers will reveal [significant cost information] to a retailer.”

Skunks and chimps

Behavioural economics practitioners have shown with experiments that people can value fairness over profit maximisation. In one such experiment, called the ultimatum game, one player receives some money and gets to propose how to split it with a second player.

 The second player must accept the proposed division for either of them to receive any cash; otherwise, both end up with nothing.

Classical economic theory suggests that the proposer should keep as much as possible for himself and offer, say, just 1 percent to the person across the table. In reality, responders typically reject splits in which they receive less than 20 percent. In some cultures, people will even reject splits of less than 50:50.

“The ultimatum game tells you that people aren’t hard-nosed economists,” Zhang says. “They are fair minded … We are saying that you don’t need a hard-nosed attitude to make a profit in the real world.”

The three scholars’ theory assumes that the retailer cares about fairness and shows how this can lead to better outcomes for both. But Zhang believes that this is a reasonable approximation of how people really conduct themselves.

“This is behaviour that we’re indoctrinated in,” he says. “If we behave unfairly, we feel bad about ourselves.”

Findings in the emerging field of neuro-economics, which combines economics and neuroscience, reinforce these ideas, the scholars say in their paper. Researchers have done magnetic resonance imaging (MRI) scans on people’s brains while they are receiving offers like the ones in the ultimatum game.

When subjects feel they have been cheated, a part of the brain called the anterior insula lights up – the same area that responds when they smell something disgusting, like a skunk.

Chimpanzees recently have been shown not to be burdened by the same sort of economic scruples. A study by scientists at the Max Planck Institute of Evolutionary Anthropology in Germany found that chimps had no concern for fairness. Working with raisins, they would accept any division as long as they received at least one raisin, rejecting only offers where they got nothing. They were, in other words, more economically rational, in the classical sense, than humans.

Zhang acknowledges that, in the real world, people’s conduct can resemble that of chimps: “You do have to watch out for opportunistic behaviours.”

Sometimes, social norms will prevent these people from trying to take advantage of those with whom they do business. They might be concerned about their reputation, or they might act fairly out of fear of reprisal.

“When you don’t have repeated interactions, that’s when you have to worry,” Zhang says. “It’s like a tourist who doesn’t leave a tip on the table because he thinks he’ll never come back to the restaurant.”

Republished with permission from Knowledge@Wharton (http:// knowledge.wharton.upenn.edu), the online research and business analysis journal of the Wharton School of the University of Pennsylvania