Firms often pay workers the same exact wage for a given job, regardless of workers’ productivity levels. Such wage compression—when wages vary less than the marginal product of labor—can distort employment levels and reduce firm productivity and growth. A potential reason for wage compression is fairness norms against wage inequality, which are perceived as higher in developing countries. Specifically, if workers are paid below a reference wage—which depends on their co-workers’ wages—they will retaliate by reducing effort. As a result, it can be profit maximizing for firms to pay workers similar wages. However, there is scant field evidence on whether such relative pay comparisons actually matter for the workplace.
To fill this gap, this project uses a field experiment in which full-time workers are organized in teams, and teams are randomized into different pay structures. In some teams, all workers are paid (random) homogenous wages, and in other teams workers are paid heterogeneous wages based on ability. This is cross-cut with information treatments on co-workers’ wages and productivity. Effects on individual and team-level output will be used to assess the importance of relative pay comparisons in the workplace.
Understanding the labor market distortions generated by wage compression is an important first step before policy recommendations on how to improve labor allocation can be constructed. If wages are flexible, firms can hire heterogeneous workers full-time and pay them different wages based on productivity. However, in the presence of wage compression, firms will value the ability to hire more able workers more often, and only turn to less able workers to fill labor gaps when necessary, e.g. through casual daily labor markets (Dreze and Mukherjee 1989). In this way, wage compression will decrease the profitability of formalizing employment arrangements. This study’s survey data will help provide evidence that firms pay workers similar wages, and use differential employment rates to reward more able workers. This, in turn, would suggest that wage compression may hinder the transition to formal labor arrangements.
This research will thus yield valuable policy implications on how firms can mitigate distortions from paying heterogeneous wages. First, providing workers with information on co-workers’ productivity may help justify wage dispersion. Second, firms may be able to pay heterogeneous wages while avoiding effort retaliation through how they structure the organization of work.
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