Fairness, Errors and the Power of Competition

One of the most basic questions in economics concerns the effects of competition on market prices. We show that the neglect of both fairness concerns and decision errors prevents a satisfactory understanding of how competition affects prices. We conducted experiments which demonstrate that the introduction of even a very small amount of competition to a bilateral exchange situation – by adding just one competitor – induces large behavioral changes among buyers and sellers, causing large changes in market prices. Models that assume that all people are self-interested and fully rational fail to explain these changes satisfactorily. In contrast, a model that combines heterogeneous fairness concerns with decision errors predicts all comparative static effects of changes in competition correctly. Moreover, the combined model enables us to predict the entire distribution of prices in many different competitive situations remarkably well.