The utility of pay raises/cuts: A simulation experimental study
Introduction
Merit pay is arguably the most popular incentive system used in business today, although its effectiveness continues to be debated in the academic and practitioner-oriented literature (Heneman, 1992, Pfeffer and Sutton, 2006, Shaw and Gupta, in press). On the one hand, Gerhart and Rynes (2003) concluded that the sparse existing evidence on merit pay is mostly positive including links to job satisfaction, motivation, and performance. On the other hand, few organizations describe their merit pay programs as “very effective” (e.g., see Wells, 2005), a large majority of employees believe they are underpaid (by an average of 19 percent) (Heneman & Judge, 2000), and average pay raise levels fall short of, or barely exceed, inflation. Against this backdrop, it is particularly problematic that although we “talk, think, argue, and dream about it …” “… money as a central research topic has not been given much attention by management research” (Mitchell & Mickel, 1999: 568).
One of the problematic issues is that merit pay research tends to be conducted in several parallel paradigms, each with its own set of assumptions. Management and applied psychology researchers tend to adopt a linear approach and assume that higher raises are incrementally more valuable (e.g., Schaubroeck et al., 2008, Shaw et al., 2003). Some researchers adopt a non-linear, psychophysics approach and assume that pay raises below a certain threshold may go completely unnoticed (e.g., Mitra et al., 1997, Mitra et al., in press). Other researchers, based on economic theory, suggest that money has diminishing marginal utility, but debate persists about the form of the function (Giles and Barrett, 1971, Heneman et al., 1997, Jevons, 1871). Indeed, although management, economics, psychophysics, and other approaches offer interesting insights into merit pay dynamics, these fields usually proceed independently and sometimes conflictingly (Rabin, 1998). Our understanding could be improved substantially if research from these perspectives were integrated to answer questions such as: Does a pay raise of, say $5000, evoke twice as strong a positive reaction as a pay raise of $2500?
The existing literature provides little insight and/or empirical evidence related to individual reactions to pay cuts. Unanswered in the literature are questions such as: Does a pay cut of $5000 evoke equally as negative a reaction as the positive reaction evoked by a pay increase of $5000? This is a timely question for several reasons. First, with the recent deep recession, many companies have implemented pay cuts instead of opting for lay-offs. Second, with the increasing volatility in stock option value (often implying pay cuts), many managers are experiencing significant reduction in their overall pay. Third, the growing popularity of pay-at-risk programs (e.g., Begley & Lee, 2005) provides impetus to investigate employees’ reaction to both positive and negative changes in pay.
We address these issues here. Based on the premises that the value or utility of pay is a non-linear function of the absolute amount, and that the function for losses is steeper than the function for gains (e.g., Galanter, 1962, Galanter, 1986, Galanter, 1990, Holmes et al., 2011, Kahneman and Tversky, 1979, Kahneman and Tversky, 1984), we attempt to move the information base forward by (a) offering an interdisciplinary theoretical exposition of the utility and disutility of pay raises and pay cuts; (b) testing a subset of the resulting predictions empirically; and (c) offering a refined functional form for utility/disutility based on the theoretical and empirical work. We seek to make several unique contributions. First, we integrate theoretical concepts from psychophysics, economics, and psychology to suggest a modified utility function. Second, we empirically test both the utility and the disutility of pay raises and pay cuts. That is, we specifically test the functional form of utility for pay raises (i.e., positive limb) and the functional form of disutility for pay cuts (i.e., negative limb). Third, we discuss and test disutility of small pay raises. Fourth, we use Box–Cox tests for statistical comparisons and assessment of the relative efficacy of linear, quadratic, and log-linear utility functions.
Section snippets
The inherent utility or value of money
The issue of the utility of money has a rich history (Stigler, 1950), and an understanding of the utility of money in general and pay raises in particular is critical in explaining employee motivation, attitudes, and behaviors. According to Adam Smith, the term “value” can have two different meanings: the inherent utility of an object (value in use), and the power of purchasing other goods that the possession of the object conveys (value in exchange). Things with the greatest value in use
Reference point and employment relationships: expectations and reactance
Much research on the utility/disutility of monetary gains and losses, as shown in Fig. 2a, was conducted in the gambling context which is different in several key ways from work contexts. Refinements offered by the prospect theory are no doubt valuable, but they must be supplemented with systematic identification of psychological factors that affect the utility of money in the employment context. Expectancy theory and reactance theory highlight several mechanisms that affect the shape of the
Participants and procedure
Participants were 192 student “employees” with diverse educational backgrounds at a large southern university. The data reported here were collected as part of a larger study examining the psychophysical dynamics of pay. The larger experimental simulation involved: (a) hiring student “employees” to perform a coding task at one of two base pay rates, (b) giving employees performance feedback (“satisfactory” for all subjects to hold this issue constant), (c) giving employees pay raises of
Results
Table 1 shows the results of the regression analyses using the pooled approach for affective reactions. The cumulative R2, adjusted R2, the change in R2, and the F-statistic are reported for each step. The results using the averaged approach are shown in Table 2. This approach treated the two base pay conditions separately, and results are reported separately for each. The results of the Box–Cox test, showing simultaneous assessment of the predictive power of the linear, logarithmic, and power
Discussion
This paper was designed primarily to combine knowledge from disparate disciplines – psychophysics, economics, and organizational behavior – in developing an integrative mathematical framework for understanding the utility of pay raises and pay cuts, and to begin assessing the empirical applicability of the framework. The results of this work raise both substantive and methodological issues.
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