A reinterpretation of the relation between firm-specific pay inequalities and productivity

The main objective of this paper is to question the interpretation of the usually-found positive correlation between firm-specific pay inequalities and productivity. We estimate from French employer-employee matched data this correlation and confirm that it is positive, even after accounting for fixed unobserved heterogeneity and simultaneity using instrumental variables. This result is consistent with the idea that wage inequality is one of the tools that are available to stimulate workers productivity. However, in such a framework, pay inequality is an optimization variable controlled by the firm, and should therefore appear as endogenous. This is not the case: tests show that variations in pay inequality are exogenous, i.e. they are imposed to the firm in a way that is uncorrelated to other unobserved determinants of productivity. We therefore adapt the standard model of incentive theory to make it compatible with this exogeneity property, along the lines of Lazear (1989). The model that we develop is a model where the choice of a higher or lower degree of pay inequality is fully constrained by an exogenous technical characteristic of the firm, i.e. the varying importance of collective and individual effort in its production function. In such a context, the degree of pay inequality is interpreted as an indirect measure of this technical characteristic. We confirm this interpretation by examining the relationship between pay inequality and organizational characteristics of firms measured by the REPONSE survey.