The Effects of Pay Inequality on Fairness and Effort: New Experimental Evidence

This article provides new experimental evidence on the interplay between pay inequality, procedural fairness, and employees’ productivity. We propose a novel laboratory design that enables us to: (i) isolate the effect of pay inequality on effort from other confounding factors, such as piece-rate incentives or gift exchange; (ii) understand the mediating role of procedural fairness; and (iii) directly measure employees’ stated perceptions of fairness. We find that employees perceive pay inequality to be unfair when it is not justified, but among them it is only those that are underpaid who negatively react by lowering effort. A heterogeneity analysis reveals that treatment effects are systematically larger among female and younger subjects. We conclude that unjustified, disadvantageous pay inequality significantly affects employees’ effort, and that fair procedures can help mediate its adverse effects. Therefore, pay transparency may not necessarily create adverse effort responses among employees if the wage setting procedure is transparent and designed in a way that is perceived as fair.