Any LBS that thinks that they will survive on the sale of goods is foolish. Brick and Mortar stores can only compete by adding value to the purchase. Primarily this added value comes in the form of additional services (e.g. fittings, maintenance, organizing rides, and knowledge/expertise- plus anything else they can convince consumers is worthy). The internet generally has a lower price for physical good but lacks the essential services many buyers want or need. The OP LBS is probably counting on their own competitive pricing and a tit for tat trade in service from the other LBS.

Simply put, they might believe that they do enough test rides and fittings for the other LBS to justify their recommendation that you use the other LBS. They may have a formal or informal agreement on the matter. They may accept the loss of a sale to you and hope to gain a reciprocal sale latter when the other LBS recommends the opposite action to another future customer.

Ethics are always a tricky question because people have many different notions of ethics that are based on the philosophies of many ethical theorists. I certainly have no moral problem with the suggestion (perhaps some business questions but that is different). The broad term "ethics" can however, justify many bad actions that are ethical under certain ethical philosophies. Under which ethical philosophy are you asking this question?