Signaling through price and quality to consumers with fairness concerns

Consumers with inequity aversion experience some psychological disutility when buying products at unfair prices. Empirical evidence and behavioral research have suggested that consumers may perceive a firm's price as unfair when its profit margin is too high relative to consumers' surplus. The authors develop an analytical framework to investigate the effects of the consumer's inequity aversion on a firm's optimal pricing and quality decisions. They highlight several findings. First, because of the consumer's uncertainty about the firm's cost, the firm's optimal quality may be nonmonotone with respect to the degree of the consumer's inequity aversion. Second, stronger inequity aversion makes an inefficient firm worse off but may benefit an efficient firm. Third, stronger inequity aversion by the consumer can actually lower the consumer's monetary payoff (economic surplus) because the firm may reduce its quality to a greater extent than it reduces its price. Finally, as the expected cost efficiency in the market decreases, both the expected quality and the social surplus may increase rather than decrease.