Internal and Market Pay References in Firms

Abstract

We examine how firms balance internal and external reference points when determining employee pay. Analyzing nearly 19 million confidential U.S. employee records, our analysis reveals three key findings. First, the relative sensitivity of pay to internal over external benchmarks increases with firm innovation intensity, employee skill level, and the combination of the two. Second, this relationship appears at least partly causal: we document similar patterns using an instrumental variables analysis based on regional inflation shocks and a differences-indifferences analysis of CEO transitions. Third, firms with a stronger internal pay orientation produce more and higher-quality patents, including more breakthrough innovations. Altogether, our findings reveal that, while some firms maintain close market alignment, knowledge-intensive firms appear to decouple pay from market forces. This is particularly the case for their skilled workers, consistent with firms prioritizing internal social dynamics in contexts where cooperation and creativity are important for value creation.

Keywords: Compensation, Pay benchmarking, Social comparison, Theory of the firm