Imagine that your country is currently experiencing an inflation rate of 10.5% (as it was in the UK in December 2022). The government decides to increase the salaries of public sector employees by 3.5%. Would you say that is fair?
Now imagine exactly the same scenario, except that inflation is 7% (rather than 10.5%) and the government decides to freeze salaries. Do you think that is fair?
And finally, what do you think about a situation in which there is no inflation (a prevailing rate of 0%), and the government decides to reduce the salaries of public sector employees by 7%. Do you think that is fair?
The interesting point here is that in all three scenarios, real wages decrease by exactly the same level: 7%. So from a purely rational, economic perspective they are the same.
But when we randomly allocated these different scenarios to three different groups and asked them to say whether they thought they were fair or not, we got three different answers.
In the first scenario with high inflation, 36% thought the modest salary increase was fair.
In the second scenario, with mid-level inflation, 23% thought a salary freeze was fair.
But in the third scenario, in which inflation was 0% and salaries decreased by 7%, the proportion of people who thought this was fair fell to just 14%.
To understand why these different perceptions of fairness exist, we have to turn to some of the classic papers in the field of behavioural science.
When Daniel Kahneman, Jack Knetsch, and Richard Thaler conducted a similar study in 1991, for example, they attributed their similar findings to the fact that a pay cut feels like a loss. On the other hand, an insufficient pay rise feels more like a ‘foregone gain’. And generally speaking, we experience losses as significantly more painful than foregone gains.
As Kahneman, Knetsch, and Thaler noted, this is why organisations might find it relatively easier to cut real wages during inflationary periods than they would during periods of lower inflation.
This, of course, is exactly the scenario that is playing out in countries around the world, including the UK, where salary increases are being offered, but they are not in line with the prevailing rate of inflation.
So the next time you are offered a change in your salary, think about how you would feel if you adjusted the rate of inflation up or down, but kept your real world increase or decrease constant. You may reconsider the fairness of the deal.