The influence of potential on wages and effort

Abstract

We investigate how employee potential influences wage offers and effort exertion in a gift exchange experiment. In particular, we test if gift exchange based on a commonly accepted norm for wage differentiation can emerge in a setting where the wage demands of agents are heterogeneous. We also analyse how communication by principals responds to the unequal wage demands and how it influences agents’ decisions about working effort in the presence of varying degrees of bargaining power. We find that differences in productivity and the resulting entitlements lead to differentiation in wages. High productivity agents are offered substantially higher wages than low productivity agents. Results from a control experiment suggest that a large part of this wage markup is related to the future productivity potential of high performers. At the same time, unequal wage schemes do not substantially crowd out effort exertion: we observe no strong detrimental effects from disadvantageous relative wage positions. Certain communication patterns significantly influence effort exertion.