ONE OF THE most common misconceptions that many otherwise intelligent people fall
prey to is that markets are fair. I can’t tell you how many times my students have told me that, I’ve heard politicians say it, and I’ve read it in popular press articles. Yet that notion
is simply wrong.

Using markets as a means of distributing goods and services can assure that the maximum possible number of beneficial transactions will take place. That’s what social efficiency means. However, efficiency has little to do with assuring that people’s needs are met in a fair and just way.

Markets are efficient
The notion of fair markets stems from the idea of fair pricing. A price, of course, is nothing more than the dollar value that a buyer agrees to give a seller and a seller agrees to take in exchange for providing a good or service. In any price transaction, there are typically a range of prices at which a buyer and seller can agree, at which both would be happy to trade. When parties agree on a price that falls below the most that the buyer is willing to pay and above the least that the seller is willing to accept, they’ve got a deal.

These respective values are referred to as each party’s reservation price (RP). Together, RPs set the boundaries of what we in the negotiations business call the bargaining zone, or the zone of possible agreement (ZOPA). Whenever the bargaining zone, or ZOPA, is positive (i.e., greater than zero), trade should occur. There is value to exchange; both parties are better off trading than not. This is because each party can, in theory, reach an agreement that is better than their reservation price. Conversely, whenever the bargaining zone, or ZOPA, is negative, trade should not occur. Both parties are worse off trading than not.

To make this concrete, let’s consider an example. Jane is selling Penny a used stereo. Jane
is willing to go as low as $105. Penny is willing to go as high as $120. Thus, the seller’s reservation price is $105, and the buyer’s reservation price is $120. The bargaining zone is between $105 and $120. If Jane and Penny agree to trade, the price will fall somewhere in
that range.

Note that in this model any price that falls within the bargaining zone is acceptable and expected. There is no right or "fair" price by definition. Any price that meets or beats
both bargainers’ reservation prices is fine. Each negotiator’s tactical goal is to settle as far away from his or her reservation price as possible–to claim as much of the excess surplus
for oneself.

Now, a market is what we get when we look at buyers and sellers at a system level. Beginning with the bargaining zone model, we rotate price from the horizontal axis to the vertical axis, and put quantity on the horizontal axis to represent the full volume of possible trades. Often we can define the demand curve as consisting of all buyers’ reservation values arranged in descending order. Likewise, the supply curve can consist of all sellers’ reservation values arranged in ascending order. Thus, the buyer with the highest reservation price starts out the demand curve, as does the seller with the lowest reservation price. The vertical distance between the two points represents the bargaining zone that would be available if those two traders met in the market.

Of course, markets are typically not that orderly. Buyers and sellers match up in a more randomized manner, and the bargaining zone changes from transaction to transaction within a market. For example, in the figure below, the buyer depicted at point A may meet up with a seller depicted at point B or C.

By definition, efficiency happens when social welfare is maximized–when there is no way to make someone in the economy better off without making someone else worse off. In markets, that means that for all possible combinations of traders, every possible combination that involves a positive bargaining zone takes place. From theory, we know that so long as markets are characterized by perfect competition, the market clearing price is efficient. Any seller with a reservation price below that point is willing to trade, as is any buyer with a reservation price above that point. All mutually beneficial trades that can occur do occur, and we maximize utility. Thus, economic theory tells us that free, unfettered, perfectly competitive markets are the most efficient way to allocate goods and services. Recent economic history certainly seems to bear that out.

But are markets fair?
Theory tells us that markets are efficient, but are they fair? Before we can assess that, we first have to have some understanding of what being fair means. It turns out that this is more easily said than done. (Try to come up with a simple definition of fairness and you’ll see.) It is a topic that many researchers in both psychology and economics have pondered of late.

The whole idea of fairness appears to emanate from social comparison processes and the need for predictability in life. People don’t like to feel exploited, to be thought of as suckers, to be uncomfortably surprised in social settings. People do like to feel valued, respected, and in control. Yet satisfying that need set is complex, because life truly isn’t "fair." There are seldom the resources or time necessary to address each need for each person in a social situation. Thus, our efforts at being fair to others or being treated fairly by others are always imperfect.

Fairness, in part, can be thought of as a judgment that people make regarding social outcomes–that is, how benefits and payoffs get distributed across people within an interaction. In these contexts, fairness judgments represent the degree of equality or inequality across parties’ payoffs that is considered acceptable within a given situation. As an example, people often think of even splits as fair–especially among friends. "We’ll split the tab 50­50." In business, people often define fairness in terms of equity, in proportion to earned rights or inputs. Those who contribute more, in terms of investment or generating sales or profits, get more out in terms of financial rewards. Sometimes when goods can’t be divided, people consider chance outcomes to be fair; many times people will agree that whomever wins the coin flip gets the prize. Across all of these examples, fairness norms help organize expectations about which social outcomes are considered normatively appropriate or acceptable.

From psychological research, we know that people not only value fair outcomes but they also value the actual experience of being treated fairly. We like it when others are respectful to us, when others consider our point of view, when things go the way that we expect them to. Thus, people also value fairness in process, as well as outcomes, and apply norms of procedural fairness to make these judgments.

From a procedural perspective, there are some aspects of markets that appear fair and some that don’t. For example, one of the fair aspects of markets is that they allow everyone equal access. Typically anyone can participate, regardless of gender, race, religious orientation, etc. On the other hand, this access has an income bias. The way that people participate is through economic currency. Presumably, buyers who have more money can afford to pay more for goods; they are more likely to be both willing and able to pay for goods at or above the market clearing price. Thus, those who have more get more in a market system. I’m not sure that’s fair.

Regarding outcome fairness, I often ask my students, "Will someone please tell me what’s fair about settling at the market clearing price? It is certainly efficient–economic theory and experience show us that it maximizes utility. But will someone please tell me what’s intrinsically fair about the point at which these two theoretical curves intersect?" Usually the class gets pretty quiet.

"Besides," I continue, "there’s no such thing as a market clearing price." In practice, we don’t map out supply and demand curves in real time and calculate the point at which they intersect. Instead, before negotiating, we collect recent market price data. This data tells us what other people have paid for a similar good or service. In "thick" markets like stock exchanges, where trades occur frequently and information is readily accessible, prices converge, as theory would predict. There is little variance. In "thin" markets, such as housing within a neighborhood, trades occur every few weeks at the most and it is difficult to reliably define an absolute market price. Here, people think more in ranges.

When we identify a market price (or range of prices) from this data, many people like settling at that price because they think it’s "fair." Yet, while convergent pricing within a market may feel good, it does not necessarily translate into fair outcomes in terms of allocating economic surplus. As an example, in the case of monopolies, prices maybe equal, but the seller is garnering all of the bargaining zone surplus away from the buyers. What’s fair about that?

I often think what people like about the notion of convergent or equal pricing is process-oriented. It appeals to our sense that equality is good, that every buyer/seller is getting a similar deal. It also feels safe, because we know that others settled at the same place we did–so if later, we learn of a better deal, we don’t need to feel as bad, if we’re in the same boat with others.

From an interactive perspective, settling at market price has a "warm" feeling to it. Price negotiations are by nature conflictual. Yet, in the presence of straightforward market data, both parties agree to settle at the market price, feel good about it, and move on to something else.

Fairness as a motivater and a blocker
It is my sense that fairness and social comparison processes are, in part, what drive market behavior. I would suggest that the psychological energy behind routine market search and negotiation behavior is not simply utility maximization and the desire to do better than your reservation price. It is also the desire to not come up short compared to others. As buyers, we like to do as well as or better than other buyers in a market, and to feel that sellers are not exploiting us.

For example, we don’t like learning that our neighbor just bought the same car that we did at the same dealership for $500 less–even if the price we paid fell below our reservation price. First, we don’t like learning that we are not as good at negotiating as our neighbor, and second, we don’t like feeling that the dealer took us for a "sucker." Thus, in many ways, market convergence is borne of social comparison and fairness concerns–both as we compare ourselves to other buyers or sellers in our same situation and as we reflect on how the other party in a transaction is treating us.

However, as such, fairness concerns can also be a source of trade inefficiency. There is considerable evidence that finds that people will remain at an impasse rather than accept what they perceive to be an "unfair" deal, even if that outcome exceeds their reservation price. Consider, for example, my research with Maggie Neale of Stanford, in which we have demonstrated the common intuition that more extreme opening offers can move outcomes in a direction favorable to the party making them. In other words, "high-balling" or "low-balling" can have the desired effect. We have also demonstrated empirically that extreme opening offers introduce a big risk–namely, the likelihood of impasse. This is because people care about fairness in concession making. If one party’s opening offer is much farther away from the bargaining zone than the other’s, that party will have to make much bigger concessions to move into the zone of possible agreement. The negotiator who consistently makes bigger concessions often feels that they are not being respected or appreciated. He or she wants to see reciprocation from the other side. But the other side cannot reciprocate to the same magnitude because they don’t have as much room to play. As a result, such negotiations result in impasses much more frequently, even though economic theory says they shouldn’t because the bargaining zone is positive.

To make this concrete, let’s return to Jane and Penny. Imagine that Jane has stated an opening offer of $150 (recall that her reservation price is $105), and Penny has countered with $100 (her RP is $120). Jane comes down to $140. Penny comes up to $110. Jane then goes to $130, and Penny balks. She says that she can only come up to $115. Jane says, "Okay, I can go as low as $125, but that’s it," figuring that she has been quite reasonable. Penny responds, "Sorry, I can’t do it." At that, Jane walks away thinking that Penny has been unreasonable, when, in fact, given her reservation price, Penny has not been.

On the other hand, if Jane had started at $125, the problem is likely to never have arisen, and the deal would have been made. In both cases, from an economic perspective, the deal should have taken place. In both cases, there would have been surplus created through trade.

Final comments
In real life, prices happen through trade. The "market price" represents data about the prices others have recently paid to purchase a similar good or service. This price may or may not fall at the market clearing price–the point where the theoretical supply and demand curves meet.

Markets are efficient. Markets are incredibly powerful. In fact, they are unmatched in their ability to organize people and resources, aggregate information, and create utility in complex social contexts.

However, if fairness is your concern, markets are not that. There is nothing inherently fair about supply and demand or market clearing prices. And while market price information may provide a reasonable standard for resolving a price negotiation, it, too, is not inherently fair.

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