You might think your income is working to bring you happiness.
The relative income hypothesis has something to say about that assumption.
And it might just shock you.
What Is the Relative Income Hypothesis?
The relative income hypothesis states that the satisfaction you get from spending depends on the average level of spending in your community, not the absolute amount you spend.
In other words, the relative income hypothesis says we’re status-seeking spenders, not value shoppers.
James Duesenberry first gave this idea its name in a book with the academic-sounding title of Income, Saving and the Theory of Consumer Behavior.
Duesenberry’s idea was revolutionary. The dominant thinking at the time said that as people earned more, their consumption level should stay about the same (and their savings should increase).
Put another way, lifestyle inflation shouldn’t happen according to the standard economic view pre-Duesenberry.
Except it does. People aren’t rational, as it turns out. Spending increases quickly follow income increases in a household. Sometimes they precede it, thanks to cheap, prolific credit.
Relative income hypothesis follows everything we know about “keeping up with the Joneses.”
When we live in richer neighborhoods, we start to model the spending of our neighbors. We get similarly priced cars, buying equally expensive clothes, and spring for private school instead of sending our kids to public elementaries.
The effect is pernicious because we might not be aware that it’s happening.
The sofa that was perfectly adequate two weeks ago starts to look shabby and old. We don’t credit the housewarming dinner we attended a week ago with Inception-ing that idea into our brains.
Relative income hypothesis is why embracing voluntary simplicity is hard. Peer pressure is the number one killer of the minimalist lifestyle. Lifestyle inflation is a communicable disease. Be sure to inoculate yourself.
Relative Income Hypothesis & Burnout
Relative income hypothesis has other important implications on how and why we work.
If we’re driven to consume to keep up with our peers, and we therefore overwork to increase our incomes, then the effect of status-seeking spending is burnout. Multiply this effect by millions of people and you get a nation of burnouts.
Thirty years ago, the best-paid workers in the U.S. were much less likely to work long days than low-paid workers were. By 2006, the best paid were twice as likely to work long hours as the poorly paid, and the trend seems to be accelerating. A 2008 Harvard Business School survey of a thousand professionals found that ninety-four per cent worked fifty hours or more a week, and almost half worked in excess of sixty-five hours a week. Overwork has become a credential of prosperity.
This has potentially disastrous consequences when it runs into the reality of Work Anywhere, Anytime culture.
As Mike Dang, writing for The Billfold, points out:
[I]t’s not just about cutting hours, but also unreasonable expectations. Because people who leave work and then go home to continue doing work because they’re afraid they’re going to get behind are just continuing the cult of being overworked in the privacy of their own home.
As long as we make the mistake of comparing ourselves to others, we’ll keep working each other to burnout death.
Our Brains Are Hooked on Money
The Boston Globe reported on the research of Professor Jeffrey Pfeffer of the Stanford Graduate School of Business. The research finds that the more money people make, the more they value it:
‘‘We thought it was quite possible that money was different because of its symbolic nature — when I pay you, I’m also signaling your worth,’’ Pfeffer said.
And that is what they found. The more that people earned, the more they said money mattered to them. The same correlation was not true when it came to money made from sources unrelated to work. That kind of income, Pfeffer said, has ‘‘much less implication for one’s sense of mastery or worth.’’
If true, our relationship to money contradicts a fundamental tenet of modern economics: that the marginal utility of an item decreases as you acquire more of it.
That’s a fancy way of saying your tenth iPad is worth less to you than your first one.
But money doesn’t seem to have this limit.
That worries me.
If we are defining ourselves by how much money we earn and we always spend what we earn (e.g. the average savings rate always hovers around 0%), then we’re all on a collective escalator to nowhere.
This explains why the guy with $1 billion is unhappy because his neighbor has $10 billion.
If decreasing marginal utility applied to money, we wouldn’t see this problem. We’d accumulate “enough” money, however much that is, and be content.
Unfortunately, our brains don’t seem to be wired this way. At least not without intervention.
You’re Wealthier Than You Think
The constant spending race against the Joneses doesn’t seem to serve anybody’s interests.
Writer Casey N. Cep sees another downside to always looking upward for comparison:
Greed is a suit that’s tailor made: it finds a way to fit every lifestyle, no matter how much or how little you earn. It will always be easier to look at the super-rich and pity ourselves than it will be to look at the super-poor and realize how much we have to give. The economic tide may be raising the yachts higher and higher, but even those of us in dinghies and lifeboats can help the billions who are drowning.
It’s uncomfortable to say this in a time of economic uncertainty for this country, when many are unemployed and others are underemployed, but there are still many of us whose poverty is mostly imagined: we struggle to pay for the lifestyles we think we deserve when billions struggle to live. The inconvenient truth is that most of us have more than we need and spend more than we should.
Whenever I find myself starting to think this way, I visit Global Rich List. Global Rich List lets you plug in your income or wealth and compare it with everyone in the world.
Most folks complaining about the 1% in the U.S. are one-percenters themselves compared to the rest of the world.
That doesn’t excuse crippling social immobility or income inequality here in the States.
But it is a reminder to find gratitude in being alive today in the wealthiest period in human history. Even though it doesn’t feel like it some days.
The “Permanence” of Money
Essentially, the realization I had is that money is permanent. You have it until you trade it for something, and then that trade is permanent — you are thereafter permanently without that money. It’s gone and belongs to someone else now. Therefore it’s important to consider the permanence of whatever benefit you traded it for.
I don’t think “permanence” is quite the word David’s looking for here. Money is pretty impermanent. On a basic level, money can be regenerated … unlike time, which can’t.
But I get what David is saying here. Money is still money in another year’s time, even if it’s worth a bit less due to inflation.
Whenever you trade your money away, you should consider the value of what you’re getting in return.
The value of what you get in return for your money should be equal to or greater than the value of the money itself. Otherwise, you should simply keep your money.
If what you’re getting in return for your money is a brand new car, for instance, that’s typically a bad trade. You’ve just traded $30,000 for an asset that will lose 25% of its value the moment you drive it off the lot.
That’s why I say buying a car is one of the three quickest ways to short-circuit an agile lifestyle transformation. There are too many ways to make a bad trade for your money in a car-buying situation. The whole system is stacked against making good decisions.
5 Ways to Beat the Relative Income Trap
#1 Decouple Income from Self-Worth
As Professor Pfeffer discovered, if you signal your self-worth with salary, no amount of money will ever be enough. The first step is to see your value as a human being in non-economic terms. Your worth as a spouse, as a partner, as a parents, as a sibling, etc. can’t be reduced to dollar figures.
#2 Decouple Spending from Income
I call this one of the top ten personal cash management strategies for good reason. As long as spending keeps increasing with income, we’ll never get ahead. The reality of hedonic adaptation is that increased spending doesn’t make us all that much happier.
#3 Practice gratitude
Hop over to Global Rich List if you need a reminder of how well you have it now at the dawn of the 21st century. Even the richest kings of Persia didn’t have the access to the travel, entertainment, and medicine that you do today.
#4 Keep the Trade Value of Money in Mind
David Cain’s observation about the trade value of money is important. Just because you can “afford” that luxury car doesn’t make it better value for the money. Are you purchasing value or are you purchasing status?
#5 Fix Budget, Flex Scope
What’s the 80/20 of what you’re doing? Agile and Lean Startup practices teach us that if we can’t fit everything in within the time and budget we have for them, we should pull back the scope. Fixing budget and flexing scope gets you to focus on what’s important. Is that $1,000 vacation side trip that critical to your enjoyment? Or is it the extra time you get to relax with your friends and family?