This is another situational question that can easily catch many applicants off guard if they are not prepared and cause them to stumble in their answer, resulting in an unfavorable opinion during the interview. You may not have ever thought about how you would respond in this type of situation unless you have been directly faced with it so when you are preparing for an interview it is a good idea to give it some thought.
The best way to handle this type of question is to apply the situational guideline. This means that you would respond based on the given situation. In this case, your response to the situation might depend on the type of inappropriate behavior that is displayed. If two coworkers are involved in a physical altercation and it is in an area where customers could easily walk in then you might explain that your first response would be to make an attempt to bring the situation under control so that others are not injured and then report the behavior immediately to a superior.
On the other hand, if the improper behavior that is displayed is more of a personal nature then you might explain that your response would be to talk to the individuals involved and explain that the behavior was not appropriate for the workplace and that it should stop. If the behavior did not cease at that point you might then report it to management.
As you can see, a situational question can often result in a situational type answer. These types of questions can be very hard to predict because you never know exactly what the interviewer will ask, but you can be better prepared for handling such questions by taking the time to practice ahead of time and make sure you understand what it is that the interviewer wants to gain from your response to the question. In this case, it is likely that the interviewer wants to find out how you would handle potentially embarrassing or difficult situations and where your loyalties would lie if there was a problem with co-workers. In other words, would you cover up the behavior in order to remain on friendly terms or would you be loyal to the company and report behavior that could potentially harm the company in some way.