Businesses are often portrayed as rapacious partners, seeking to squeeze every penny out of their deals. Indeed, some are… the result is often a relationship between defined by a fat contract that seeks to protect both parties against bad behavior by the other. New research, which draws on both conventional research and brain-scan driven neuroeconomics studies, reaches the surprising conclusion that fairness is the key to maximizing profits:
A manufacturer and a retailer can both end up making 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 maximizing their individual profits, Zhang, Raju and Cui [John Zhang and Jagmohan Raju, both of the Wharton School of Business, and Tony Haitao Cui, a University of Minnesota marketing and logistics professor] argue in a paper recently published in Management Science titled, “Fairness and Channel Coordination.”
When people are fair minded, they don’t need to waste time on elaborate negotiations or enter into complicated contracts to coordinate their marketing channel and maximize profitability… [From Knowledge@Wharton – In the Game of Business, Playing Fair Can Actually Lead to Greater Profits.]
Part of the researchers’ thesis is based on a popular tool of behavioral economics: the Ultimatum Game, a two-player game in which one player divides a sum of money between the two and the second player either accepts the split or rejects the deal. If the deal is rejected, neither player receives any money. Traditional economic logic suggest that the second player should accept any non-zero split. For example, even if the first player decides to keep $18 out of $20 and give the second player only $2, that $2 payment is still better than nothing and should be accepted. In fact, most players will forgo the $2 and reject the deal as unfair. In some cultures, anything that deviates from a perfectly “fair” 50-50 split will be rejected. People expect fairness, and will take a loss themselves to enforce it. Further evidence comes from fMRI brain scan data:
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.
What the research suggests that companies that operate in a consistently fair and transparent manner should be able to develop relationships with like-minded firms and together maximize profits. Over the years, I’ve seen such relationships work well for both parties. Honest dealing on both sides, an absence of rancorous price negotiations, and good communication by both sides, go a long way to a smooth relationship. Most importantly, when one side does have a problem – say, a price squeeze due to market conditions or a schedule crunch of some kind – it can often be worked out between the parties with each giving a little.
I’d contrast that with the way that, for example, US auto companies have developed almost adversarial relationships with their suppliers in order to procure components at the lowest possible cost. While low costs are critical in the worldwide auto business, Japanese firms seem to emphasize cooperation to a much greater extent. U.S. auto component suppliers particpate in the adversarial relationship with problematic behavior of their own. Currently, a few miles from our office, Hummer production has been shut down by a strike at GM supplier American Axle. It’s hard to imagine either management or the workers at a Japanese auto supplier taking an action that would shut down Toyota’s production lines. (I suppose the fairness doctrine might apply to the relationship between a company and its workers as well; at many unionized firms in the US, it seems that management/labor relations are mostly about each side extracting as much as possible from the other.)
The “fair play” approach may not be applicable to every business situation – sometimes tough negotiations and comprehensive legal agreements may be in order. Even in “one shot” deals, though, like a one-time capital equipment purchase, perceived fairness is likely to produce better results. I’ve seen construction contracts where the buyer staged an extremely competitive bidding process; by the time the contract was awarded, the low bidder had little or no profit in the job. In order to make money on the job, the contractor would then have to count on change orders (small contract increases when the buyer changes something) which could be padded with extra profit because the buyer has no practical alternative. The result? An adversarial relationship with the contractor looking for ways to stick it to the buyer, and the buyer perhaps forgoing needed and desirable modifications to the plans.
I’d never advocate blind trust in any business deal, but the research confirms what successful business people have always known: operate in a fair, honest, and transparent manner and both you and those you do business with will make money.