Merit pay and wage compression with productivity differences and uncertainty

This paper experimentally investigates wage setting and effort choices in a multi-worker setting when there is heterogeneity in worker productivity and managers' perception of this productivity is imperfect. Worker ability is assigned via an aptitude test and, in an innovative design, manager uncertainty concerning this ability is related to the manager's own test performance. We propose a merit-pay hypothesis, that higher-ability workers will reduce their effort if they are not paid more than coworkers with lower ability, but not vice versa. Based on a simple model, we also predict that the higher the uncertainty about employee ability levels, the more managers compress wages between perceived high- and low-ability workers. We find strong experimental support for both hypotheses.