Incentives to move up: Effects of pay gaps between levels on employee performance

• Author: Hui Liao,Wei Chi,Lei Wang,Qing Ye,Rui Zhao
• Date: 01 April 2019
• DOI: http://doi.org/10.1111/1748-8583.12221
• Published date: 01 April 2019

ORIGINAL ARTICLE

Incentives to move up: Effects of pay gaps

between levels on employee performance

Wei Chi

1

|Hui Liao

2

|Lei Wang

1

|Rui Zhao

3

|Qing Ye

4

1

Department of Leadership and Organization

Management, School of Economics and

Management, Tsinghua University

2

Department of Management and

Organization, Robert H. Smith School of

Business, University of Maryland

3

Department of Economics, University at

Albany, State University of New York

4

Department of Management Science and

Engineering, School of Economics and

Management, Tsinghua University

Correspondence

Hui Liao, Department of Management and

Organization, Robert H. Smith School of

Business, University of Maryland, 4506 Van

Munching Hall, College Park, MD 20742, USA.

Email: hliao@rhsmith.umd.edu

Funding information

National Natural Science Foundation of China,

Grant/Award Numbers: 71490723,

71302019, 71728005 and 71421061;

Tsinghua University Research, Grant/Award

Number: 20185080054

Abstract

Employees of a certain rank are motivated by the pay gap

between them and the levels above (upward comparison),

and the pay gap between them and the levels below (down-

ward comparison). In some cases, employees face multiple

upward comparisons such as immediate and subsequent

upward comparisons. We hypothesise that upward compar-

ison matters more than downward comparison, and in the

case of multiple upward comparisons, the immediate one

matters more than the subsequent ones. We also

hypothesise that the pay gap effect resulting from the

upward/downward comparison ought to be non‐linear in

that performance increases with pay gap size at a decreas-

ing rate. The results from two empirical studies, namely, a

longitudinal field study and a laboratory experiment, largely

support our hypotheses.

KEYWORDS

hierarchical pay gaps,incentive design, non‐linearity, performance

1|INTRODUCTION

Although chief executive officer (CEO) pay has been in the research, media, and policy spotlight, we need to examine

firm compensation hierarchies more broadly, beyond the pay gap between the CEO and average employees

(Connelly, Haynes, Tihanyi, Gamache, & Devers, 2016) to understand the full incentive effect of a firm's pay structure

on employee performance. The internal labour market in a medium‐sized or large organisation usually has several

hierarchical levels, and as a result, there are pay gaps between levels (Gupta, Conroy, & Delery, 2012). Employees

in such organisations usually face multiple pay gaps both upward and downward. Building upon and extending

existing research on pay gaps, we draw on two theoretical perspectives—tournament theory (Lazear & Rosen,

1981) and income comparison (Adams, 1965; Brown, Gardner, Oswald, & Qian, 2008; Clark, Kristensen, &

Westergård‐Nielsen, 2009; Clark & Oswald, 1996, 1998; Festinger, 1954)—to discuss and predict the performance

implications of various vertical pay gaps. In particular, we examine (a) an immediate upward pay gap, which is the

Received: 27 May 2016 Revised: 1 October 2018 Accepted: 17 October 2018

DOI: 10.1111/1748-8583.12221

238 © 2018 John Wiley & Sons Ltd Hum Resour Manag J. 2019;29:238–253.wileyonlinelibrary.com/journal/hrmj

pay gap between the employees and one level above them; (b) a subsequent upward pay gap, which is the pay gap

between the employees and two levels above them; and (c) a downward pay gap, which is the pay gap between the

employees and the level below.

Compared with previous research on pay gaps in the internal labour market, our contribution is primarily empir-

ical, aiming at providing a clean and concise application of these theories in the context of a large organisation. First,

previous studies have focused on the effect of the pay gap between executives and employees on firm performance

(Bognanno, 2001; Connelly et al., 2016; Conyon, Peck, & Sadler, 2001; Eriksson, 1999). We enrich this picture by

examining the different effects of various vertical pay gaps in the organisational hierarchy. In addition, we examine

the effect of vertical pay gaps on the more proximal outcome of individual performancerather than on the frequently

examined but more distal outcome of firm performance.

Second, our study is related to and adds to the labour economics literature that uses experiments to study the

incentive effect of different prize structures in a tournament setting (Altmann, Falk, & Wibral, 2012; Delfgaauw,

Dur, Non, & Verbeke, 2015; Freeman & Gelber, 2010; Sheremeta, 2010; Stracke, Höchtl, Kerschbamer, & Sunde,

2014). It is most closely related to Freeman and Gelber (2010), which examined prize spread (i.e., pay gap) and the

performance of experimental participants. Our study differs from theirs; however, in that, we adopt the two‐round

tournament setting and propose a non‐linear relationship within each round. In terms of the two‐round design, our

study is similar to the experiments conducted by Altmann et al. (2012), Delfgaauw et al. (2015), Stracke et al.

(2014), and Sheremeta (2010); our extension to these studies lies in testing the differential performance effects of

first‐and second‐round tournaments as well as in conducting a field study in addition to a laboratory experiment

so as to examine the two‐round tournament in a corporate context.

Third, we integrate social comparison and tournament theory to examine the non‐linear relationship between

pay gaps and performance. Extending previous studies (e.g., Freeman & Gelber, 2010; Lazear & Rosen, 1981;

Moldovanu & Sela, 2001) which have examined such a non‐linear relationship from the perspective of employee het-

erogeneous ability, we conduct empirical tests to demonstrate the added value of the social comparison perspective.

Last but not least, our study also contributes to the practice of pay structure design. It sheds light on the critical

practical question of how firms should design pay structures. For example, companies with the same pay gap

between executives and employees could be rather hierarchical at the top and compressed at the bottom, or vice

versa. Such different pay structures will have different performance implications for employees. Therefore, separat-

ing overall pay gaps into multiple ones allows us to extend the literature by providing a finer understanding of how

pay gaps may affect individual performance.

2|THEORY AND HYPOTHESES

In the internal labour market, a whole package of incentives influence employee performance (Baker, Gibbs, &

Holmstrom, 1994; Lazear & Shaw, 2007). Employees are incentivised by base pay and performance‐based bonuses,

as well as promotion and career paths. Promotion and career incentives are then influenced by pay dispersion

between corporate hierarchical levels. Additionally, for career paths and pay gaps to influence one's performance,

individuals need to have some knowledge about the “corporate ladder”as well as the pay gaps between them and

levels above. In this study, to examine the performance impact of pay gaps between the hierarchical levels, we con-

trol for other aspects of incentives such as the amount of pay (base pay and bonus) and conduct a survey to verify

that employees have some knowledge about pay gaps.

Regarding the effects of pay gaps on employees' motivation and performance, two theories can be applied. First,

tournament theory argues that employees are incentivised through tournaments (Lazear & Rosen, 1981; Rosen,

1986; see also Connelly, Tihanyi, Crook, & Gangloff, 2014, for a review). The larger the spread among the prizes

(i.e., the prize differentials between different levels), the greater the tournament effort elicited. In the organisational

context, this translates into the prediction that the larger the pay gaps between ranks in an organisational hierarchy,

CHI ET AL.239