(By N. Taylor Thompson)

In interpersonal experiments, around 85% of people tend to punish unfairness, given the chance, even when it is costly and has no immediate payoff to them. This helps explain the risks to firms of implementing strategies that customers deem unfair.

Remember Netflix — with the DVDs that came in the mail?

In July 2011, Netflix decided to unbundle its streaming and DVD products. This move was textbook strategy. In fact, it is taught at HBS as an example of how economically informed decisions can benefit both company and customer.

Textbook logic goes something like this: you’re charging $10 per month for a subscription to all your customers, who value streaming and DVD services differently. On average, 35% value streaming at $10 and DVDs at $2; 35% value streaming at $2 and DVDs at $10, and 30% value both streaming and DVDs at $8. If you unbundle prices, charging $8 for each service, 70% of your customers are better off! Cinephiles pay $8 for DVDs only, Youtubers pay $8 for streaming, and impatient cinephiles pay $16 for both. And Netflix also wins, increasing its total revenue 4% and attracting new customers to buy lower-priced individual services.

But, as we know, when Netflix tried such a change in 2011 the outcome was different: outrage,  opprobrium, subscription cancellations. Netflix lost a million customers in the month after unbundling. My dad still won’t use Netflix, because they “tried to screw him.”

Fairness, it turns out, is critical to understanding customers’ perceptions of your business.

What happened? 

Netflix triggered people’s fairness response. Customers interpreted unbundling not as a move that would create consumer surplus, but as one designed to profit at their expense. So they canceled subscriptions, not based on any rational calculation, but rather to punish Netflix.

Executives could have predicted this reaction, had they studied psychology and sociology, as well as economics.

Customers think businesses with higher prices must have higher profits. Consumers consistently underestimate firm costs and overestimate profits, attributing price differences to profit, and conclude that prices are unfair. Interventions such as providing historical prices, explaining price differences between businesses, and suggesting costs customers hadn’t considered are only modestly effective at decreasing perceived unfairness.

Customers think prices should only go up when costs do. They think it’s fair to maintain prices as costs decrease or to raise them if costs increase, but not to raise them if costs remain constant. Increasing prices because of increased demand is seen as unfair. Usually, firm profit is seen as “at the customer’s expense.”

Customers infer bad motives when businesses raise prices. These negative inferred motives make customers see price increases as less fair, and decrease satisfaction and desire to buy again. The importance of motive also suggests that price discrimination to help “the less fortunate” is OK – senior citizens’ discounts, for example — and that transparently explaining motives can reduce the harm from increasing prices.

Customers think higher prices for quality is fair. Customers are willing to accept price increases for better product quality, suggesting that firms should demonstrate better quality as justification for price increases.

Most people will punish unfairness, given the chance. In interpersonal experiments, around 85% of people tend to punish unfairness, given the chance, even when it is costly and has no immediate payoff to them. This helps explain the risks to firms of implementing strategies that customers deem unfair. 

Why do these lessons matter? 

Fairness — and the tendency to punish unfairness — is instinct, which we transfer from personal interactions to firm interactions.

Netflix could have anticipated the risk of a fairness response to unbundling, quantified the potential cost, and either opted not to unbundle or sought to mitigate the risks. They might have been more transparent about what they were doing and why, and communicated their decision in a way that speaks to concerns over fairness:

  • Licensing costs for streaming content are rising as content owners renegotiate licenses. These costs do not affect DVD users, and it would be unfair to charge them separately.

  • Most customer rely heavily on either streaming or DVDs, so separating the services will lower costs and make most people better off.

  • We are separating our services so each can focus exclusively on increasing quality for streaming or DVD movie consumption. For example, Netflix just acquired licenses for a number of new films.

Obviously, Netflix isn’t the only company to make this mistake. Customer retaliation can take place whenever companies follow a similar unbundling strategy, but also in bundling or even routine price increases and experimentation. But fairness also creates opportunities for innovation.

Industries known for poor customer service or abusive policies — unfair practices — can create situations where their customers are waiting for a chance to retaliate. Gyms and some software services that create artificial exit barriers and misleading renewal policies are examples of industries that may be at risk of this.

An HBS professor once advised me, “Never use the word ‘fair’ in business – always use ‘reasonable’ instead.” While good negotiating advice, it missed a deeper point: fairness is hardwired into humanity and ignoring its business implications is costly.

What do you think?

(Source: HBR)

“Opinion pieces of this sort published on RISE Networks are those of the original authors and do not in anyway represent the thoughts, beliefs and ideas of RISE Networks.”