When A Raise Doesn't Feel Like A Raise

Applying the principles of marginal utility of income, the Easterlin paradox, and Kahneman's prospect theory to the idea of employee raises.

Picture this: You've finally landed that coveted job or received a long-awaited promotion, leading to a significant boost in your income. Initially, the extra dollars bring a sense of relief and accomplishment as you pay off debts, indulge in luxuries, and perhaps even plan for the future. But as the novelty wears off, you might find yourself wondering why, despite your financial success, true contentment still feels out of reach.

This is where the common idea of the $75,000 income threshold comes into play. Studies conducted in the United States have suggested that, up to an annual income of around $75,000, increases in income are indeed linked to improvements in happiness and life satisfaction. It's the point where financial stability meets basic needs, providing a buffer against the stresses of everyday life.

But why $75,000? The figure isn't arbitrary; rather, it represents a tipping point where the benefits of additional income begin to plateau. Below this threshold, higher earnings can alleviate financial strain, affording individuals access to necessities like food, shelter, and healthcare. Yet, beyond $75,000, the correlation between income and happiness becomes less pronounced. While more money might still offer perks, such as greater flexibility or the ability to enjoy occasional indulgences, its impact on overall well-being diminishes.

It's essential, however, to recognize that the $75,000 threshold isn't a one-size-fits-all rule. In New York City, for example, that threshold could be $750,000. But the idea of diminishing returns to income still holds.

I’ve been thinking a lot about compensation, raises, and the best ways to approach handing out compensation increases within organizations. Is there any way to keep everyone happy throughout the course of their career? Is there a minimum threshold for the amount of money a raise can or should be?

I’ve come up with an idea. But first, here are a few ideas you need to know.

The Easterlin Paradox

The Easterlin Paradox, named after economist Richard Easterlin, posits that while income and happiness may dance together momentarily, the rhythm of economic progress does not always synchronize with the melody of contentment. This conundrum arises from the fundamental human tendency to measure one's fortune not in absolute terms but in comparison to others.

Consider the scenario of a salary raise. Initially, the influx of additional income brings joy, elevating one's perceived well-being. However, this elation is ephemeral when viewed through the lens of societal progression. If everyone experiences a similar increase in wealth, the relative standing remains unchanged, akin to a zero-sum game. If this newfound affluence is accompanied by a surge in the cost of living, the net effect on happiness may even be negligible or negative.

Kahneman and Prospect Theory

Prospect Theory paints a vivid picture of how we perceive gains and losses. Picture a spectrum where each dollar gained holds less emotional weight than the one preceding it. This phenomenon encapsulates the concept of diminishing marginal utility—a principle stating that as our wealth grows, the incremental joy derived from each additional unit of wealth diminishes. In simpler terms, a millionaire may find less delight in gaining another dollar compared to someone living paycheck to paycheck.

Conversely, the theory sheds light on our reaction to losses. Here, the narrative takes a poignant turn. As individuals, we exhibit a propensity for experiencing heightened distress when confronted with financial setbacks, especially in leaner times. This asymmetry in emotional response encapsulates the notion of increasing marginal disutility—a concept asserting that the pain inflicted by a loss amplifies as one's financial standing dwindles.

To illustrate, imagine losing $100. For someone with substantial wealth, this may evoke a mere shrug—a minor inconvenience in the grand tapestry of their finances. However, for someone living on the brink of financial stability, this loss could reverberate with profound anguish, casting shadows of uncertainty and hardship.

Marginal Utility of Income

Marginal Utility of Income is the idea of the incremental satisfaction or well-being derived from an additional unit of income. Imagine, if you will, a thirsty traveler in a desert, parched lips yearning for a sip of water. The first gulp quenches the most profound thirst, providing immense satisfaction and relief. Yet, as the traveler continues to drink, the subsequent sips offer diminishing levels of satisfaction. This diminishing return on each additional unit of water mirrors the concept of diminishing marginal utility—a core tenet of the Marginal Utility of Income.

In practical terms, consider a scenario where an individual receives a pay raise. Initially, the infusion of extra income brings about a tangible increase in well-being—a better standard of living, perhaps, or the ability to indulge in life's luxuries. However, as income continues to rise, the incremental joy derived from each additional dollar diminishes. The second sports car may not evoke the same thrill as the first, nor does the fifth vacation elicit the same sense of novelty as the first.

Conversely, the concept of diminishing marginal utility operates in reverse when income declines. In times of financial strain, the loss of a single dollar can evoke a disproportionately higher level of distress—a stark manifestation of the harsh reality that losing financial security exacts a heavier toll than the mere numerical value suggests.

The idea of marginal utility of income is shown of the graph above, which shows a curve that starts off increasing steeply, then flattens out, and eventually begins to curve downwards. This means that as someone’s income increases, the additional satisfaction they get from each extra dollar starts off high but eventually tapers off and even becomes flat, in theory.

For example, the first few dollars someone earns might bring them a lot of satisfaction because they can afford basic necessities. But as their income increases, extra dollars provide less and and less additional satisfaction.

All or Nothing

Now that we’ve explored the theories behind happiness and income levels, here is the idea: organizations should only dole out additional compensation, and call it a raise, once they match this formula:

Raise = Cost of Living Adjustment + Salary Increase Enough To Reach Next Level on Marginal Utility of Income Curve

Regular raises that don't keep up with the cost of living or that fall short of the next marginal utility level might actually demotivate employees. They might see it as a loss or a missed opportunity, especially considering the effort they put in to get the raise.

Returning to this chart, the idea would be that if an employee is at $70,000, and during their annual performance review they are eligible for a cost of living adjustment and a raise, then that raise should reach $80,000. Any less and the increased compensation is a cost of living adjustment.

On the flip side, the organization should not increase greater than $80,000 at that moment in time UNLESS the organization can reach the next threshold on the curve. The idea is that raises need to always land on the marginal utility of income curve.

What To Do When Between Thresholds

So now you ask how do we look after our team members when they are between points on the marginal utility of income curve? The first is messaging. Everyone in the organization needs to understand that there will be a focus on raises that have a significant impact. Instead of giving everyone a small raise every year, target raises for those whose income puts them behind or isn't keeping up with the cost of living. This ensures a more substantial increase in their income which, according to Kahneman's research, is more likely to lead to a significant increase in happiness

Secondly, consider alternative rewards. Because financial rewards aren't the only motivators, we should think about offering additional benefits, flexible work schedules, or opportunities for professional development that might be more meaningful to some employees.

Bottom Line Benefits of Aligning Compensation to the Marginal Utility of Income

Granted, aligning compensation increases with the Marginal Utility of Income curve involves a strategic approach to resource allocation within organizations. Here's how this alignment can optimize resource allocation:

Targeted Investment

By identifying employees who are below the next threshold on the Marginal Utility of Income curve, organizations can strategically allocate resources to those who stand to benefit the most from a raise. This targeted approach ensures that compensation increases are directed towards individuals for whom the additional income will have the greatest positive impact on their well-being and motivation.

Maximizing Returns

Investing in raises that align with the Marginal Utility of Income curve maximizes the return on investment for organizations. Rather than spreading resources thinly across the entire workforce, companies can focus on areas where incremental investments are most likely to yield significant improvements in employee satisfaction, engagement, and performance. This targeted approach ensures that limited resources are allocated in a way that generates the highest possible returns in terms of overall organizational effectiveness.

Retention and Productivity

By addressing disparities in compensation and proactively meeting employees' evolving needs, organizations can enhance retention rates and productivity levels. Employees who feel valued and fairly compensated are more likely to remain with the company and remain motivated to perform at their best. This, in turn, contributes to a more stable and productive workforce, ultimately benefiting the organization's bottom line.

Strategic Advantage

Adopting a compensation strategy that aligns with the Marginal Utility of Income curve can also confer a strategic advantage in the competitive talent market. Companies that prioritize employee well-being and offer compensation packages tailored to individual needs are more likely to attract and retain top talent. This can give organizations a competitive edge in recruiting efforts and position them as employers of choice within their industry.

Cost-Efficiency

While investing in targeted raises may initially require a higher upfront investment, the long-term benefits can outweigh the costs. By optimizing resource allocation and focusing on areas that drive the greatest impact on employee satisfaction and performance, organizations can achieve cost-efficiency in their compensation strategies. This ensures that resources are allocated effectively, resulting in a higher return on investment and overall financial sustainability.

Last Thought

This is just one concept I’ve had thinking about the difficult equation that is employee compensation, but the idea of aligning compensation increases with the Marginal Utility of Income curve presents a compelling strategy for me when thinking about organizations seeking to optimize their resource allocation while fostering employee satisfaction and performance.

By targeting investments where they can make the most significant impact and maximizing returns on investment, companies can enhance retention rates, productivity levels, and their competitive advantage in the talent market.

At the end of the day, employee happiness is the core of performance. While raises are always appreciated, I’m sure we can all think about times when we handed out a raise and received no emotional response on the other side of the table. This is my attempt at limiting those interactions.

What a weird and wonderful world,