Internal Pay Equity and the Quantity-Quality Trade-Off in Hiring

Michael Amior and Shmuel San

No 21191, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Firms face significant constraints in their ability to differentiate pay by worker productivity. We show how these internal equity constraints generate a quantity-quality trade-off in hiring: firms which offer higher wages attract higher skilled workers, but cannot profitably employ lower skilled workers. In equilibrium, this results in workplace segregation and pay dispersion even among ex-ante identical firms. Our framework provides a novel interpretation of the (empirically successful) log additive AKM wage model, and shows how log additivity can be reconciled with sorting of high-skilled workers to high-paying firms. It can also rationalize a hump-shaped relationship between firm size and firm pay, and provides new insights into aggregate-level, regional and sectoral variation in earnings inequality — which we explore using Israeli administrative data.

Keywords: Firm size; Wage-setting; Monopsony (search for similar items in EconPapers)
JEL-codes: J31 J42 (search for similar items in EconPapers)
Date: 2026-02
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