Does fairness breed efficiency? Pay gap and firm productivity in China

The pay gap (PG) between executives and employees has received considerable attention. PG may incentivize employees to work hard for promotions; alternately, it may also lead to inequity aversion and decrease employees' work effort. We examine these two competing theories about the effects of PGs on firm productivity. By incorporating incentive and inequity aversion hypotheses into one model, we find that productivity is an inverted-U function of PG. Supporting evidence is provided using wage expenses of listed firms in China. To establish causality, policy shocks are introduced. We further show that outside job opportunities and employees' skills significantly moderate the inverted-U relationship.