Pay Harmony: Peer Comparison and Executive Compensation

Abstract

This study finds that peer comparison affects both wage setting and productivity within firms. We suggest that a 1991-1992 controversy over executive pay led to increased wage comparisons within firms, particularly within those with geographically dispersed managers – managers with the greatest information frictions. We report three changes in division manager compensation following the controversy: i) pay in dispersed firms co-moves more and is less sensitive to individual performance, ii) pay disparity between managers located in different states decreases relative to that of co-located managers and finally, iii) division productivity falls in dispersed firms, particularly among managers at the low end of the wage distribution. Taken together, our findings suggest that principals account for horizontal peer comparison when designing executive wage contracts and that this comparison has productivity consequences for firms.