Sunday, 9 December 2012

Starbucks and fairness

Starbucks has been hitting the headlines for all the wrong reasons recently. First up was the news that the company has paid corporation tax only once in 15 years of operating in the U.K. This has seemingly been achieved by making royalty payments, and the like, to parts of the business in lower tax jurisdictions. Customers, taxpayers, and the tabloid media were suitably annoyed. Starbucks’ response was to say that it would ‘voluntarily’ pay £20 million in tax over the next two years. The thought of Starbucks ‘volunteering’ to pay tax seems to have aggravated rather than calmed the situation! On Saturday, tax avoidance campaigners protested outside a number of stores forcing some to temporarily close.
    Starbucks is certainly not alone in avoiding tax - Amazon and Google also usually get a mention. And they are certainly not the first company to ‘annoy’ customers on fairness grounds. For example, an accusation even more damaging than that of tax avoidance is one of using forced labour. The latest accusations came in June when a report by Anti-slavery International claimed that many U.K. high street retailers such as Tesco and Marks and Spencer were selling clothes made by girls working under slave conditions in India. Customers didn’t like this news much either. More generally, customers seem to rebel against any company ‘not playing fair’.
    Making sense of this is difficult if you rely on the standard economic textbook. Fairness is not supposed to matter. Seemingly it does. So, how can we put fairness into the mix?  Let’s start with a diagram that should be familiar to anyone who has done a bit of microeconomics.
    Suppose that the demand for Starbucks coffee is given by curve D. The textbook story is then as follows: We derive Starbucks marginal revenue curve (MR) and their marginal cost curve (MC). Starbucks maximizes profit by finding the point where marginal revenue equals marginal cost MR = MC. So, they should charge £4.00 for a cup of coffee. The last cup of coffee they make costs them £0.75 and so they make £3.15 profit on this. Overall, their average costs (AC) are £1.00 and so they make a profit of £3.00 on every cup of coffee sold.

Let’s take a step back at this point, and revaluate. We know the last customer is willing to pay up to £4.00 for a cup of coffee. We also know Starbucks makes a profit if it charges more than £1.00 for a cup of coffee. So, any price between £1.00 and £4.00 benefits both the customer and Starbucks. This leads to what Game theorists call a bargaining problem. The important question, is what price the customer and Starbucks shall ‘agree’ on? The textbook answer to the question is simple: Starbucks can ask for £4.00 and the customer will pay it. Reality may be somewhat different.
    In particular, research on the ultimatum game suggests that customers are unlikely to be willing to pay £4.00. In the ultimatum game a ‘proposer’ makes an offer of how to split, say, £3.00. The ‘receiver’ can then either accept the offer or reject. If he rejects the offer no deal is done. In the Starbucks example there is a £3.00 surplus (£4.00 – 1.00) to be bargained over. Starbucks sets the price for a cup of coffee, which is an offer of how to split the surplus, and the customer can either accept the offer by buying the coffee, or reject and not buy the coffee.
    Many people in the ultimatum game reject ‘unfair’ offers. Someone, for instance, offered 10 pence out of £3.00 may reject the offer. Similarly, someone charged £3.90 for a cup of coffee may not buy the coffee. Note that this does not contradict the fact that the customer was willing to pay up to £4.00 for a cup of coffee: he is willing to pay £4.00 if the deal is fair, e.g. if Starbucks costs are £3.90; but, this deal does not look fair and so is rejected. 
    This point was nicely illustrated in a paper by Richard Thaler in Management Science *. In one well known example people were asked to imagine they are lying on the beach on a hot day. A friend offers to get a beer and asks you how much you are willing to pay. Some were told the only place to buy a beer is a fancy resort hotel. Others were told it’s at a small run-down grocery store. Thaler found that survey respondents were willing to pay on average $2.65 to buy a beer from a ‘fancy resort hotel’, but only $1.50 from ‘a small, run-down grocery store’.  The basic willingness to buy beer is surely the same in both cases. People just don’t want to be ripped off by the run-down grocery store. 
    The key point here is that the transaction between the customer and Starbucks becomes a bargaining problem where fairness is likely to matter. Thaler suggested that we capture this by distinguishing acquisition and transaction utility. Acquisition utility captures the basic willingness to pay - £4.00 in the Starbucks example. Transaction utility captures the pleasure or otherwise of buying the good, and this is where fairness matters. If the customer feels he is being ripped off being charged £3.90 for a coffee he may decide to do without coffee. 
    Starbucks, and any other firm, therefore, has to strike a compromise between charging a high price and not annoying the customer too much. That’s where tax avoidance comes in. Suppose, Starbucks charge £3.50 for a cup of coffee and the customer is happy with that deal. He then learns that Starbucks is paying no corporation tax. Suddenly, £3.50 may not seem like such a ‘fair’ bargain; the customer may realise, for instance, that Starbucks costs are not as high as he thought they were. This sense of unfairness lowers his transaction utility from buying a coffee at Starbucks. The customer is no longer willing to pay £3.50. 
    Starbucks has two choices at this point: lower prices, or make £3.50 seem fair again. I would be surprised if Starbucks lower prices. So, they need to make £3.50 seem fair. The offer to pay taxes in the future is presumably an attempt to do that. Fairness, however, is a difficult thing to earn. This was beautifully illustrate in a study by Daniel Kahneman, Jack Knetsch and Richard Thaler published in 1986 in the American Economic review **. They found some interesting distinctions between behaviour customers consider fair and that they consider unfair. Our understanding of such issues is, however, incomplete. For example, Kahneman, Knetsch and Thaler found that respondents considered it fair for firms to pass on higher costs in the form of higher prices. What happens if a firm like Starbucks ‘passes on’ higher costs without actually incurring the higher cost? We don’t know. 
    One thing we do know is that any transaction involves an element of bargaining and fairness. Economists have not really taken this issue seriously enough, but the troubles at Starbucks remind us how important an issue it is.

* Richard Thaler (1985) ‘mental accounting and consumer choice’ Marketing Science.
** Daniel Kahneman, Jack Knetsch and Richard Thaler (1986) ‘Fairness as a constraint on profit seeking: Entitlement in the market’ American Economic review.

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