Pay Spread and Skewness, Employee Effort and Firm Productivity

by

Paul Bingley1 and Tor Eriksson2

Abstract. We test predictions from theories of tournament, fairness and tastes for skewness about the effects of pay spread and skewness on employee effort and firm productivity. The data come from the population of 6,501 medium-to-large sized Danish private sector firms matched with all their employees during 1992-95. Potential simultaneity problems are addressed by instrumental variables provided by institutional variation in the income tax system. Differences in firm productivity effects between occupational groups and types of firms give support to the theories of fairness, tournaments and tastes for skewness. Only individual effort effects support tournament theory alone.

JEL Codes: J31, J41. Keywords: Tournaments, fairness, skewness, pay distribution, matched employeremployee data.

Acknowledgements. We are grateful for funding by the Danish Social Research Council. Sren Leth-Srensen and Claus W. Andersen created the original data set and made this work possible. The paper has benefited from the comments of participants at workshops in Helsinki, Warwick and rhus, in particular Martin Browning, Martin Conyon, Chris Ferrall and Edward Lazear. Remaining errors are our own.

1. National Centre for Register-based Research (NCRR) and Department of Economics, Aarhus University 2. Department of Economics, Aarhus School of Business

1 Introduction
Incomplete contracts and dysfunctional responses have been important elements in the growing literature on the internal labour economics of the firm.1 Workers focus on rewarded aspects of performance, in particular those that are measurable. Since contracts incompletely specify desired worker behaviour, agents respond to objective contracts for private benefit, which may be harmful to the employer. Multitask agency models have extended this earlier literature to allow workers several instruments. Multi-dimensional effort gives agents greater scope to game a compensation system to their private advantage. Rank-order tournaments are a setting where agents compete against each other for fixed prizes. They provide a simple structure, which can be extended to incorporate aspects of incomplete contracts and multitask agency. Tournament theory provides many testable predictions, which articulate that in certain contexts weak incentives may be more effective in eliciting desired performance than high powered, but dysfunctional ones. This paper tests several predictions from tournament theories of firm compensation structures, and thus, adds to the rather small empirical literature on theories of organizational hierarchies and pay structures.2 Previous studies have primarily been concerned with special groups of employees, and managerial workers in particular. Moreover, most previous studies have tested only a few theoretical predictions at one time. As emphasized by Prendergast (1999), the literature suffers from empirical identification problems, as many empirical outcomes are consistent with several competing theories and distinguishing between them is difficult. Care is taken to discuss alternative non-tournament behaviour also consistent with the data. The burden of proof is somewhat greater than other studies in that firstly we examine different parts of firms where tournaments as well as other theories should be differentially evident, and secondly we consider both individual and collective effort/performance measures for which theories predict distinct outcomes. There are three novelties distinguishing this from previous empirical tournament studies as well as other analyses of the relationship between wage dispersion and productivity. First, evidence is sought for tournaments in the whole pay distribution of firms in terms of several outcome measures, which allow testing of common and distinctive theoretical predictions.3 Second, predictions are examined from multi-task
1

See Gibbons and Waldman (1999) for a survey. Prendergast (1999) provides a recent review.

To our knowledge the only other paper looking at tournaments and the whole pay structure of firms is Winter-Ebmer and Zweimller (1999). However, they do not use conventional corporate or individual performance measures, but proxy them by wage level. This obviously leads to intractable simultaneity problems in the relation between pay spread and pay level.

agency tournament extensions, especially Lazear (1989). Third, identification is emphasised by exploiting institutional differences which provide exogenous contract variation. The data analysed comes from a large, longitudinal linked employer-employee administrative register containing the population of medium-to-large sized firms operating in Denmark together with all of their employees during the period 1992-95. The data set allows us to distinguish between broad groups in the occupation hierarchy and between single- and multi-plant firms, a feature that is exploited in examining organizational form implications. We make use of two alternative performance and effort measures at the firm level: total factor productivity and sickness absence. Potential simultaneity of firm performance and pay distribution is addressed using instrumental variables. The instruments are derived from institutional variation provided by the Danish income tax system. The remainder of the paper is organized into five sections. The next section briefly sketches the theoretical background and in section 3 previous empirical evidence is discussed. The fourth section contains a data description and presents the empirical strategy. Our estimation results are presented and discussed in section 5. A final section provides a summary and concludes.

2 Theoretical background
A tournament is a setting where agents compete against each other for a fixed set of prizes. The interest in tournament structures in a labour economics context is motivated by two simple observations. First, empirical studies (Baker, Gibbs and Holmstrm 1994, Cue 1996, Farrell 1997) as well as casual evidence show that promotions, which can be thought of as prizes in the terminology of tournament theory, are important for individual wage growth. Second, as what matters in tournaments is relative (as opposed to absolute) performance, the setting does not suffer from a common noise problem. The basic, single-period rank-order tournament model (Lazear and Rosen (1981)) provides several predictions, which are amenable to empirical testing. To illustrate some points of the Lazear-Rosen model, let us look at a very simple model with two identical players indexed j and k. The game has two fixed prizes; W1 that is received by the winner and a smaller prize W2 goes to the loser. The players output, q, depends on her effort level, , and a random component, : (1)

qi = i + i , i = j,k

The effort function is C = C(), with both first and second derivatives positive. The probability of winning depends positively on the players own effort and negatively on the competitors effort. Thus, the expected utility of player j is (2)

p(W1 - C(j)) + (1-p) (W2 - C(j))

where p is the probability of winning. The probability that j wins is then (3)

prob (qi > qj) = prob (k - j) < (j - k) = prob ((j - k) > ) = H(j - k),

where = k - j ; h(), H is the cumulative distribution function of and E()= 0. Each player maximizes (3) by choosing the effort level. Optimum conditions are: (4) and (5)

(W1 W2)(p/i) - C/i = 0

(W1 W2)(2 p/i2) - 2 C/i2 < 0

In Nash equilibrium, j = k, and the outcome of the game is random: (6)

(W1 W2) h(0) - C/i = 0

Given (6) and assuming that firms maximize profits per worker, the optimum pay spread is: (7) and (8)

(W1 W2)/2 = C()

W1 W2 = h(0)-1

According to equation (6), equilibrium effort is increasing in the prize spread. In the case with several positions (players), it can be shown that prize increment increases with higher prizes, or in other words, that the prize-position relationship is convex. Furthermore, from (6) and (8) it can be seen that the convexity increases as performance measurement becomes more noisy (i.e., h(0) decreases). Allowing for several players, the probability of winning obviously becomes smaller. How effort is
4

affected is examined by McLaughlin (1988), who shows that the prize spread is increasing in tournament size, that is, pay rises associated with promotions increase as the number of contestants grows. Another extension considered by Knoeber and Thurman (1994) is mixed and biased tournaments, that is when players know their own as well other players abilities. They demonstrate that mixed and biased tournaments reduce performance for the best contestants as well as other players.4 Rosen (1986) extends the basic tournament model to account for dynamics by examining sequential elimination contests.5 Why do firms run sequential contests? One argument is that since rank is easier to observe than individual output, it is cost efficient to have winners play winners. In Rosens model career trajectories are the outcomes of competition among peers to attain higher rankings and better-paid jobs over the life cycle. The reward structure influences competition at each stage of the game. Since performance incentives at each stage include an option value on competing in all successive higher stages, it follows that in order to maintain incentives throughout the game, an extra reward is required for the overall winner (typically, the CEO). If players are risk averse, the incentive maintaining prize structure requires strictly increasing inter-rank pay spreads. Sequential elimination contests, therefore, give rise to skewed pay distributions. Consequently, in addition to pay spread, we should expect pay skewness to affect performance in compensation which is structured like a tournament. The original model of Lazear and Rosen (1981) and their followers was formulated in terms of one-dimensional effort. Lazear (1989) extends the rank-order tournament model to allow that in addition to productive effort (from the firms perspective), which furthers the agents, own success directly, the agent can also improve her own chances of success by non-productive effort (sabotage or lobbying to make competitors look bad) to induce rivals failure. This can easily be modeled by augmenting the players production and effort functions with a sabotage parameter, , showing the harm inflicted on the other player. The first-order conditions for the employees maximization problem now become: (9)

(W1 W2)(p/i) = C/i

and

Baker, Gibbons and Murphy (1994) is an example of another one-dimensional effort paper where the social and private optimum effort diverge, but in a non-tournament framework. In the working paper version, Lazear and Rosen (1979), of their 1982 article Lazear and Rosen had a section on sequential games. Rosen (1986) expands on this.

(W1 W2)(p/) = C/
Without strategic behaviour the first-order conditions for the firms maximization problem are: (10) (1-(C/)) /W1 = 0 and

(1-(C/)) /W2 = 0,
whereas in presence of strategic behaviour they are: (11)

(1-(C/)) /W1 - (1 + (C/)) /W1 = 0

and

(12)

(1-(C/)) /W2 - (1 + (C/)) /W2 = 0

Since (C/) > 0, equilibrium effort is lower when players behave strategically against their competitors than when they do not. The optimum prize spread is smaller with sabotage than in the case where one worker cannot affect co-workers productivity. 6 The employer is assumed to only observe total individual worker effort and cannot distinguish between effort, which is productive and unproductive. So individuals with the lowest cost of effort will be promoted, regardless of effort type. If there is a positive correlation between types of effort, i.e. productive individuals are also good saboteurs, then the population of tournament winners will over-represent good saboteurs (Lazear, 1989). Hence, saboteurs should be increasingly present higher up in the hierarchy as competitive or aggressive players rise to the top. Relative payment of higher-level workers is potentially quite damaging because of the greater degree of potentially counterproductive behaviour among that group. Optimum prize spread will be smaller at senior levels of the hierarchy since sabotage is of increasing relevance. Alternatively, relative comparisons between competitive workers should only be made where they cannot affect each others performance.7 Especially higher-level
6

Other two-dimensional effort papers, which do not assume a tournament compensation structure, are Itoh (1992) and Milgrom and Roberts (1988). See Carmichael and MacLeod (1993 and 2000) for empirical analyses of worker cooperation.

workers, who can be particularly counterproductive, need to be kept apart.8 This can be achieved for example by organising work by product rather than function. Firms, which replicate organisational structures at several distinct sites, keep managers apart. If there are only weak complementarities in production between managers then the incentive benefits of the greater pay spread which will be allowed if they are located separately may dominate. Thus, optimum pay spread is expected to be larger in multiplant compared to single-plant firms. Allowing workers to affect the productivity of co-workers has implications for the structure of relative compensation and for organizational form. When it is not possible to keep competitive individuals apart, firms have to use less high-powered incentives by compressing pay dispersion for workers to compete with each other less aggressively in order to avoid counterproductive effort.9 It is simple to show that allowing multitasking in a sequential tournament leads to a similar counterproductivity result to that found in the repeated or one-shot tournament case, only now it is too much skewness which induces the wrong type of effort.10 The important result of Lazear (1989) is that within relevant groups, some wage compression is efficient. The efficiency argument does not need to appeal to notions of fairness, whereby workers own utility includes a term in co-workers utility, which is the key feature in fairness/reciprocity analyses. This literature typically builds on psychological research using experiments in game settings or survey investigations to postulate that firms and workers operate under a fairness constraint.11 Behavioral game theory, motivated by apparent anomalies for standard game theory, which are produced in experimental settings, has made progress analysing situations where players care about social allocations, fairness and perceived intentions of other players.12 If firms set wages for some workers below what is perceived as a fair level, their workers will respond by reducing effort. Three other arguments for why it may be socially advantageous to compress the wage structure have been suggested.13 The first is that reduced wage dispersion speeds up
8

Milgrom (1988) and Holmstrm and Milgrom (1991) are related analyses outside a tournament framework with similar implications for organisational design. Another multitask agency paper is Baker (1992) which is similar to Lazear (1989) in that contracting on a single agents value contribution is ruled out. By extension to Lazear (1989). Examples are Frank (1984), Akerlof and Yellen (1990) and Levine (1991a and 1991b).

10

11

12

Rabin (1993) is an early discussion of fairness equilibria. Camerer (1997) gives a brief introduction to behavioural game theory. Agell (1999) provides an extended discussion.

13

the rate of structural change by eliminating low-productivity sectors or firms and subsidizing high-productivity performers. This is frequently referred to as a motivation for centralised wage bargaining.14 A second argument is that smaller pay differentials may provide incentives for skill formation as increased relative wages of unskilled workers leads to a reduced demand for them, wage compression creates incentives for schooling (Agell and Lommerud (1997) and Acemoglu and Pischke (1999)). A third rationale for wage compression is that it may act as a social insurance against changes in individuals relative position in the wage distribution (Agell and Lommerud (1992)). The applied gambling literature has long evidenced betting market inefficiency through long shot bias. This is the phenomenon of positive rates of return for hot favourites. Players are found to bet on long shots to a higher degree than justified by rates of return. Recently this apparent negative risk aversion has been rationalised by tastes for prize skewness.15 It is useful to summarize the essential predictions from the tournament papers we have discussed, and contrast these with competing theories, so that they can be placed in the context of our empirical work. In a one-shot tournament game between two players, it is the prize spread, which creates incentives for effort. Extending this to more players and more prizes, prize skewness is shown to be important. These results are carried over to repeated tournaments. However, in a sequential elimination tournament between two players, it is the option value of competing in future rounds of the tournament which leads to prize skewness rather than spread driving incentives. All of the prize spread and skewness results have to be moderated in a multi-task setting where more than one type of effort is allowed, to the effect that after a point spread and skewness become net counter-productive. The type of behaviour induced depends, of course, on the incentive structure. However, in our empirical context we do not know exactly what game the agents are playing. Furthermore, it is certainly not explicitly set up as a rank-order tournament, especially for its own sake. But if some pay structures exhibit important tournament features, do workers act according to theory? Since we do not have access to narrowly defined job levels, we cannot establish whether workers are on a career track or in a dead end job16, whether they
14

See Hibbs and Locking (2000) for an aggregate time-series analysis on Swedish data of productivity effects. Golec and Tamarkin (1998) were the first to find tastes for skewness in betting markets, analysing the apparent market inefficiency anomaly of long shot bias in horse race betting. Garret and Sobel (1999) find similar tastes for skewness among lotto players. Baker, Gibbs and Holmstrm (1994) and a number of followers describe careers in large corporations. The promotion perspectives differ widely between jobs, and an interesting research question is whether incentives are found to differ accordingly.

15

16

could be thought of as playing a sequential or repeated game, respectively. In practice we would expect to find a mixture of the two, and it is an empirical question which we shall be examining in this paper, whether incentives can explained accordingly. What predictions are common to tournaments, tastes for skewness and fairness theory? (1) Pay spread after a point reduces collective productivity for tournaments and fairness. Pay skewness increases collective productivity both in tournament and taste for skewness models. Although the recent applied gambling literature has not tested whether utility decreases in skewness after a point, casual evidence that most prize structures are not winner-takes-all would suggest that skewness too might also reduce collective productivity if it becomes high enough. (2) The effects of pay distribution in multi- versus single-plant firms may simply be a question of relevant reference group for calculating spread. The part of the within-firm between-worker pay spread which is between plants is irrelevant for fairness and makes sabotage more difficult in tournaments. (3) Different parts of the hierarchy may have different effects on productivity anyway, if there is a magnification effect of any behaviour at the top. This suggests that tournaments, fairness and tastes for skewness may be observationally equivalent. What prediction does tournament theory deliver that tastes for skewness and fairness theory do not? The Lazear (1989) model has essentially two different types of effort, only one of which is collectively counter-productive. Own private effort should not exhibit counter productive effects. Only tournament theory makes this distinction.

3 Previous empirical research

The empirical analysis of tournaments has followed two routes. One asks whether, given an explicit tournament reward structure, agents do respond as theory predicts. These studies have used either experimental data (Bull, Schotter and Weigelt, 1987) or data from sports (Ehrenberg and Bognano, 1990a and 1990b on golf). The only study of a business setting is Knoeber and Thurman (1994) who examine how a tournament compensation structure affects the behaviour of broiler chicken producers. The other approach asks whether tournament-like settings are associated with behaviour suggested by the theory and has primarily examined whether there is evidence of tournaments in the structure of top managers compensation. The early studies focused on only a few predictions (examples are OReilly, Main and Crystal (1989), Leonard (1990) and Lambert, Larcker and Weigelt (1993)), whereas two more recent papers, Main, OReilly and Wade (1993) and Eriksson (1999), have attempted to test a more comprehensive set of predictions. In the main, these studies have produced evidence indicating tournaments are present in the compensation of managerial employees. Thus, they as well as a number of other studies (for example

Conyon and Peck (1999)) find that the pay-job level relationship is convex. There is also support for the prediction that pay differentials increase with the number of contestants and/or declining promotion probabilities. However, the evidence on the effects of pay spread on firm performance is mixed. Leonard (1990) and Main, OReilly and Wade (1993) do not find that greater pay dispersion is associated with better company performance, whereas the results in Eriksson (1999) show a significantly positive, albeit quantitatively relatively weak, relationship between managerial pay spread and firm profitability. Three studies have been concerned with multi-task settings. Cowherd and Levine (1992) examine the determinants of customer-assessed quality in US and UK firms and find that pay differentials between managers and blue collar workers as well as within the management group reduce quality. Drago and Garvey (1998) use Australian workplace survey data and find that increased promotional incentives give rise to higher effort, as proxied by reduced absenteeism, and that a wider pay spread leads to more individual effort but less time spent on helping co-workers. In a recent study, Hibbs and Locking (2000) test for fairness amongst other hypotheses on Swedish aggregate time-series data. They do not find that wage compression within workplaces or industries have had productivity enhancing effects. The authors do not discuss nor attempt to test predictions from tournament models. Although there seems to be some empirical support for tournament predictions in various settings, several limitations of the available evidence should be noticed. It is not very surprising that explicit tournament settings (like sports) give rise to predicted incentives. However, most labour contracts are considerably more complicated. Hence, the results from explicit tournament contexts may not necessarily apply to many businesses. As pointed out by Prendergast (1999), outside sports, the empirical research on tournaments, and incentive schemes in general, has focused on agents, such as executives, whose output is easily observed.17 Again, the strength of the evidence of these studies seems limited, as it is obvious that most jobs are not like this. Furthermore, the literature is to some extent plagued by an observational equivalence problem in that many of the empirical outcomes studied are also consistent with alternative theories and setting up tests which discriminate between competing hypotheses is difficult. The burden of proof in this paper is somewhat heavier than in other studies. Firstly, we examine different parts of firms where tournaments as well as other theories should be differentially evident. Secondly, we consider both individual and collective effort/performance measures for which theories predict distinct outcomes.

17

An exception is Farrell (1996) on US law firm promotion tournaments.

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4 Data description and empirical strategy

Initial sample selection is the population of Danish private sector firms with 20 or more full-time equivalent employees during any year in the period 1992-95. These firms are kept for any year 1992-95 when they have 5 or more employees in each of three occupation groups: management, white collar non-managerial and blue collar. The resulting sample consists of 6,501 unique firms, each followed for on average 3.5 years, yielding 22,665 firm-year observations. The important feature of the data is the link between firms and employees which is consistent over time. Our data originates from two separate registers maintained by Statistics Denmark: the integrated database for labour market research (IDA) and the business statistics database (BSD).18 While the matched registers contain a rich set of background variables, we have access to a subset for the current study, which are now described. Business statistics at the firm-year level include annual sales, wage bill, book value of capital, industry and municipality. Worker characteristics at the person-year level include gender, age, ongoing tenure, years of education, occupation, periods of absence, home municipality, annual labour earnings at the current employer and sufficient information to calculate income tax liability. A primary goal of the analysis is to establish a link between moments of the pay distribution within firms and firm-level outcomes of interest, and to evaluate whether this relation is as predicted by tournament theory. In particular, the paper focuses on the effect of pay spread and pay skewness on firm productivity and individual effort. The economic model of Section 2 gives guidance on construction of measures of the pay distribution. Regardless of whether efficiency, fairness or tastes for skewness are the causal links driving the relation between pay distribution moments and effort, it is the part of compensation which is due to unobserved characteristics which drives incentives, equality concerns or distributional tastes. Pay dispersion, all else equal, is relevantly defined only within an appropriate reference group. Ideally, the part of compensation which remains unexplained should be within precisely defined job levels, controlling for human capital. In the absence of narrowly defined job levels, we take three broad occupations within the same firm-year as relevant reference groups and control for gender, age, education, and tenure. Specifically, we run ordinary least squares (log) earnings equations on our sample of persons once and for all, and calculate the residuals. Summary statistics and
18

It is the work of Sren Leth-Srensen and Claus W. Andersen in checking the consistency of the match between IDA and BSD which makes this work possible.

11

regression coefficients are presented in Table 1. Descriptive statistics show that the sample of workers employed in medium-to-large establishments have age, education and tenure which is slightly higher than the population of private sector employees as a whole. Regression coefficients age and tenure are conventionally quadratic. Education is negative quadratic due to the inclusion of occupation dummy variables, and reverts to a conventional positive quadratic function if occupations are omitted.19 The residuals are grouped according to occupation-firm-year cell, and for each cell, second and third moments of the residuals distribution are calculated. Table 1. Worker Descriptives and Earnings Equation Estimates (OLS)
Variable Coefficient 9.209 0.287 0.123 -0.001 -0.027 0.003 0.096 -0.005 0.211 -0.110 0.013 -0.013 0.016 Std. Error 0.007 0.001 0.000 0.000 0.001 0.000 0.000 0.000 0.001 0.001 0.001 0.001 0.001 Mean Std.dev. Intercept Male Age Age2 Education Education2 Tenure Tenure2 Manager Blue collar 1992 1993 1995 Log(earnings) Absence R2 # observations # persons Notes: log (annual earnings) managerial and 1994.

0.689 0.462 36.401 12.177 1473.326 941.687 11.325 2.489 134.446 56.520 4.898 4.016 40.111 55.591 0.101 0.583 0.245 0.241 0.260 12.179 0.709 1.648 2.295 0.435 2280607 859574 (2000 DKK) regression. Omited categories are white-collar non-

We make use of two alternative performance measures: one measuring collective and the other individual effort. Solow residual measures of total factor productivity are the most widely used and accepted measures of firm productivity (Hulten, 2000). We assume a Cobb-Douglas production function and compute Solow residual productivity measures from that. Firm-wise descriptive statistics and production function estimates are presented in Table 2. The population of Danish firms with 20 or more employees comprises somewhat smaller firms than elsewhere in the Nordic countries, Europe and the US. Business statistics on sales, wages and capital vary accordingly. CobbDouglas production function estimates exhibit conventional signs.
19

Reference groups in the earnings regression are women, non-managerial white collar workers and the year 1994.

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Table 2. Firm Descriptives and Production Function Estimates (OLS)

Variable Coefficient Std. Error Mean Std.dev. Intercept 6.896 0.038 Log(capital) 0.375 0.003 8.462 1.707 Log(wagesum) -0.356 0.005 9.104 0.943 1992 -0.023 0.011 0.250 1993 -0.066 0.011 0.250 1995 0.022 0.011 0.250 Log(sales/worker) 6.818 0.798 Capital 15975 39327 Wagesum 16109 27872 sSles 84181 168159 siSe 75 241 2 R 0.372 # observations 22665 # firms 6055 Notes: log (annual sales) (2000 DKK) regression. Cobb-Douglas production function. 1994 is the omitted year

For our measure of individual effort we follow Drago and Garvey (1998) and proxy effort by the inverse of the firms average rate of absenteeism. That is, we use the log(1-annual proportion of full-time equivalent days lost though absence) as a dependent variable. Tournament agency models require unobserved total effort. Absenteeism is only part of productive effort. Employers cannot base payment on that because of moral hazard problems of employees turning up for work when they are sick. Even though absenteeism is a noisy proxy for individual productive effort, employers not being able to contract on it, makes it a valid measure for testing tournament predictions. Having defined the outcomes of interest: collective productivity and individual (or collective productive) effort, and covariates of interest: moments of the pay residual distribution; we next turn to the primary analysis. The discussion of tournament theories in Section 2 focuses on the implications of moments of the relevant pay distribution for effort incentives. Specifically, productive effort is increasing in both pay spread and skewness up to a point, after which counterproductive behaviour dominates. This hypothesis can be tested in a regression framework as follows: (13)

ft = 12ft + 22ft2 + 33ft + 43ft2 + Xft + f + ft

where ft is productivity of firm f in year t, 2 and 3 are second and third moments of the pay residual distribution within the firm-year, s are associated vectors of

13

coefficients, Xft is a matrix of exogenous characteristics, is an associated vector of coefficients, f is a firm-specific error term and ft is an idiosyncratic error term. The null hypothesis of the tournament models discussed is that the s are respectively positive, negative, positive and negative. However, this finding alone is consistent with non-tournament explanations of productivity, such as fairness concerns. Employees in different parts of the firm may exhibit differential productivity effects predicted by tournament theory. However, fairness arguments can be extended to allow magnified counter-productivity effects higher up the hierarchy, since managers behaviour has greater impact than that of other workers. Similar productivity magnification arguments can augment tastes for skewness predictions so that they also have an occupational distributional effect similar to tournaments. Moments are computed for three different levels in the occupational hierarchy -managers, non-managerial white-collar workers and blue-collar workers -- within each firm-year. Equation (13) is then estimated separately for each occupation group. The productivity measure is always at the firm-year level since we are unable to allocate productivity between different occupations. A major empirical problem facing all observational studies of the effect of pay on firm performance is simultaneity. That is, firms which perform well may pass product market rents on to top managers, or their employees in general. However, it may not be the case that firms where top managers contracts have such a structure are necessarily those which perform well. Failure to deal with the potential endogeneity of the pay structure, could lead to biased estimates of the relationship of interest, because of the spurious correlation. It is an important contribution of the current paper that we are the first to address this issue. The structure of the Danish income tax system provides institutional variation which has the potential of being used in estimation for breaking this simultaneity. What is needed is a source of variation which determines the between firm-year differences in the within-firm pay distribution, but which at the same time does not also affect firm performance. Specifically, we need instruments for moments of the within-firm pay distribution in an equation explaining firm performance. Income tax rates in Denmark vary according to workers municipality (of which there are 275) of residence. Consequently, firms employing workers from different municipalities, have workforces with differential marginal and average tax rates, over and above that variation which is gross income related due to the piecewise linear (3 segment) nature of the income tax schedule. Assuming firm location is exogenous at the margin for productivity, between municipality income tax rate variation provides

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candidate instruments for the within firm wage distribution. Alternatively stated: exogenous regional differences in income tax progressivity identify the effect of moments of the gross earnings distribution on productivity. The part of the variation in moments of pay which is explained by progressivity is useful for determining the effects of pay moments on productivity, because that part is purged of the spurious correlation which would otherwise bias estimates. It is arguably sensible to assume that firm location is exogenous at the margin, since it is the changes in progressivity over time between regions (the difference in differences) which will identify measures of interest.20 Having discursively motivated the identification strategy, it is of course an empirical question whether our choice of instruments are statistically appropriate. Diagnostic tests are presented in a later section. Table 3. Analysis of Variance
Productivity Effort Std.dev. (Std.dev.)2 Skewness (Skewness)2 Firm 0.818 0.288 0.150 0.141 0.159 0.138 3 digit industry code 0.444 0.067 0.011 0.010 0.010 0.010 5 digit industry code 0.569 0.101 0.021 0.019 0.020 0.019 SIC3-year 0.477 0.079 0.057 0.059 0.055 0.059 SIC5-year 0.640 0.160 0.058 0.060 0.056 0.059 Municipality 0.092 0.019 0.005 0.005 0.005 0.005 Municipality-year 0.105 0.051 0.056 0.059 0.055 0.006 Note: Each cell is an R2 measure from a separate dummy variable regression. Regressions are of variables defined in the column header on dummies defined in the row header. SIC3 and SIC5 are respectively industry codes with 50 and 800 unique realisations.

The basic unit of the primary analysis is firm-year. Some important points can be noticed from the variance of outcomes (productivity and effort) and the explanatory variables (pay residual moments) of interest. Table 3 presents R2 measures of goodness-of-fit from regressions of variables defined in the column headers on dummies defined in the row headers. Each cell represents a different regression. For example, the first substantive cell is the R2 from a regression of Solow residuals on firm dummies. Firm is the first level of dummy considered. Remaining variation must be over years within-firm. To benchmark this consider 5- (800 realisations) and 3digit (50 realisations) industry codes, which respectively explain about a half and two thirds as much variation in all dimensions as firms themselves. Sweeping across the columns we can see that there is most heterogeneity between units in Solow residuals, about a quarter as much in individual effort, and much less in pay moments.21 Second and third moments have very similar between-unit heterogeneity.

20

This builds on the assumption that the costs of re-location are higher than any gain from moving municipality in order to change tax progressivity. See Papke (1991) for a counter-argument. Lazear (1999) finds that within firms, wages are compressed relative to output.

21

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It is important to appreciate that both the dependent variable and the regressors of interest in the primary analysis are themselves generated, and as such have a variance which should properly be accounted for in estimation. In order to avoid this problem, it is often simpler to perform the analysis in a single step, but in our context this is not feasible because of the different dimensionality of the first stage regressions: firmyear and worker-year. We could appeal to the fact that we are analysing a population, and leave it at that, but in the interests of generality of the results outside Denmark, we have performed some bootstrap sensitivity checks on the standard errors. 22

5 Results and discussion

Selected productivity estimates are presented in Table 4. They are easiest divided into 9 blocks of 3 columns comprising different samples (all firms, single-plant firms and multi-plant firms) and 3 rows comprising different occupation groups within the firm (managers, non-managerial white collar and blue collar). Within each of the 9 blocks are 2 columns of coefficients and associated t-statistics and 4 rows defining coefficients on pay residual moments and moments squared. Consider for example rows 1-4 in column 3, which refer to instrumental variables estimates of coefficients on moments of managers pay in a productivity regression.23 Beginning with the estimates for all firms together, presented in columns 3-4, we may see that for white collar workers (managers and non-managers), pay spread (second moment) and skewness (third moment) have a quadratic relation with productivity. That is, they increase productivity up to a point, after which they become counter productive. The counter-productivity effect is greatest for managerial workers. The latter is consistent with Lazears (1989) model according to which hawks rise to the top and therefore optimum spread is lower in the upper parts of the hierarchy. However, it cannot be ruled out that the differences between employee-groups observed, to a large extent may reflect magnification of effects at senior levels of the hierarchy.

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We drew 100 samples from the population of firms (of size 100% with replacement), and reestimated the model; then we drew 100 samples of workers, and re-estimated. Re-sampling firms had negligible impact on standard errors. However, re-sampling persons increased standard errors often to insignificance. This is mainly due to a large number of smaller firms falling below our size threshold for moment calculation. We base this conclusion on results from restricting the estimation sample to include only firms of size 50 and above, and re-sampling therefrom. Analytic and bootstrapped standard errors coincide much more closely. OLS estimates available on request.

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Table 4. Firm-Level Productivity Estimations

All firms Single-plant firms Multi-plant firms coef. t-stat coef. t-stat coef. t-stat Managers std.dev. 0.139 4.848 0.137 4.318 0.177 5.805 std.dev.2 -0.007 -3.371 -0.008 -3.379 -0.001 0.177 skew. 0.754 2.598 0.735 2.822 0.763 5.274 2 skew. -0.429 -2.632 -0.432 -3.484 -0.416 0.546 std.dev. 0.088 4.982 0.072 3.767 0.135 2.103 White collar 2 workers std.dev. -0.005 -0.735 -0.004 -2.094 -0.008 -0.949 skew. 0.631 5.890 0.635 6.688 0.793 2.264 2 -0.433 -2.512 -0.443 -2.434 -0.439 -0.311 skew. std.dev. 0.042 1.102 0.037 0.333 0.053 3.486 Blue collar -0.002 -0.121 -0.001 -1.723 -0.002 -0.248 std.dev.2 workers skew. 0.417 2.014 0.440 2.834 0.361 2.524 skew.2 -0.346 -1.246 -0.355 -1.282 -0.308 0.110 Notes: Selected IV regression coefficients explaining Solow residual productivity. Each set of 4 coefficients comes from a separate regression. The column header defines the firm sample and estimator, and the row header occupation. Other explanatories included but not presented are proportions of workers by age group, occupation, gender, education and tenure and firm size. Productivity

Blue-collar pay moments exhibit weak, if any, productivity effects. However, the relative importance of skewness compared to spread increases as one moves down the hierarchy. This finding is consistent with the idea that sequential tournaments are the more important concept lower down the job hierarchy. In other words, promotion to the next round of the tournament which allows competition for bigger prizes may be the relevant incentive rather than just the single or repeated tournament at the current job level. Splitting the sample into single plant and multi-plant firms, we turn to compare estimates in columns 5-6 with those in columns 7-8. Direct comparison of regression coefficients between the two samples is valid because the different means are washed out of higher moments and units are consistently year 2000 Danish Kroner. The incentive effects of pay moments appears to be greater in multi-plant firms. Furthermore, counter productivity effects kick in somewhat later in multi-plant firms, though these differences are hardly significant. Thus one conclusion to extract from the estimates in Table 4 is that they provide moderate support for the organisational form implications of industrial politics (see Lazear, 1989). To the extent that the between-plant part of within-firm between-worker pay spread is irrelevant for what is conceived of as fair wage differences, these findings are not inconsistent with fairness explanations. So far we have been concerned with collective effort as measured by firm level productivity. Individual effort is notoriously hard to measure, except in rather special occupations. We use the inverse of the average firm rate of absenteeism as our proxy

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measure of individual effort. Estimates of the pay moment determinants of effort are presented in Table 5. Effort is slightly increasing in pay spread and skewness for managers, more so for non-managerial white-collar workers, and there are no effects for blue-collar workers. Importantly, the counter-productive effects are absent. This is in accordance with tournament theory, since counter-productive effort is in reducing others output. This should not be captured by this selfish effort measure, that is unlikely in general to be influenced systematically by co-workers. Table 5. Individual Effort Estimations
All firms coef. t-stat Managers std.dev. 0.023 3.252 std.dev.2 0.003 3.329 skew. 0.016 7.948 2 skew. 0.110 3.746 White collar workers std.dev. 0.129 1.659 2 std.dev. 0.000 0.087 skew. 0.237 3.963 2 skew. 0.132 0.362 Blue collar workers std.dev. 0.009 0.026 std.dev.2 0.000 0.304 skew. -0.470 -1.516 skew.2 -0.256 -1.615 Notes: Selected IV regression coefficients explaining productive individual effort. Effort is defined as log(1-average proportion of year workers are absent). Each set of 4 coefficients comes from a separate regression. The column header defines the firm sample and estimator, and the row header occupation. Other explanatories included but not presented are proportions of workers by age group, occupation, gender, education and tenure and firm size.

R2 goodness-of-fit measures associated with the regressions of Tables 5 and 6 are presented in Table 6. Productivity is much easier to explain than absenteeism, and single plant firms variance is better explained than multi-plant firms. Diagnostic tests for instrument validity are presented in Table 7. They fall into three groups: F-tests for the instruments explanatory power of the endogenous variables. These tests uniformly fail, which suggests that the instruments do have the necessary explanatory power. Hausman tests have the null that OLS is consistent. This is rejected, in support of instrumental variables which are know to be consistent. The overidentification test is whether the null that instruments are legitimately omitted from the set of controls in the equations of interest. These results are a mix of acceptances and rejections. But as recent evidence has shown that overidentification tests have weak power and are notoriously too difficult to pass, especially in large datasets like ours (see Arellano, 1999), we do not place much weight on this test.

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Table 6. Goodness-of-Fit R2
Productivity All firms 0.184 0.190 0.214 Effort 0.049 0.050 0.054 # obs. 22665 Note: Goodness-of-fit associated with Tables 4 and 5 managers white collar workers blue collar workers managers white collar workers blue collar workers Single-plant firms 0.204 0.204 0.236 0.047 0.048 0.053 15466 Multi-plant firms 0.168 0.183 0.180 0.050 0.049 0.047 7199

Table 7. Instrument Diagnostics

All firms Single-plant firms Multi-plant firms test-stat p-value test-stat p-value test-stat p-value Managers F-test std.dev. 806 0.000 602 0.000 162 0.000 std.dev.2 1355 0.000 999 0.000 287 0.000 skew. 1034 0.000 794 0.000 181 0.000 skew.2 1157 0.000 877 0.000 219 0.000 Hausman prod. 56.82 0.000 43.40 0.000 15.71 0.000 effort. 6.72 0.000 3.93 0.003 8.36 0.000 Overident. prod. 20.20 0.010 16.19 0.028 5.73 0.325 effort. 6.73 0.250 3.77 0.550 5.00 0.450 std.dev. 713 0.000 710 0.000 62 0.000 White collar F-test 2 workers std.dev. 1055 0.000 1054 0.000 78 0.000 skew. 656 0.000 669 0.000 39 0.000 2 skew. 808 0.000 811 0.000 49 0.000 Hausman prod. 90.62 0.000 68.83 0.000 20.19 0.000 effort. 10.85 0.000 7.41 0.000 6.61 0.000 Overident. prod. 27.74 0.000 2.15 0.020 6.32 0.720 effort. 8.66 0.450 5.06 0.760 5.50 0.740 F-test std.dev. 836 0.000 947 0.000 72 0.000 Blue collar workers std.dev.2 1115 0.000 1269 0.000 91 0.000 skew. 521 0.000 576 0.000 46 0.000 705 0.000 782 0.000 50 0.000 skew.2 Hausman prod. 94.22 0.000 75.04 0.000 18.27 0.000 effort. 6.72 0.000 4.49 0.001 4.73 0.000 Overident. prod. 21.54 0.007 1.58 0.996 5.81 0.305 effort. 7.60 0.480 4.42 0.805 5.00 0.450 Notes: F-tests are of significance of instruments explaining endogenous variables. Hausman tests are of significance of first stage residuals in the second stage regression. Overidentification tests are uncentered R2 from regressing structural equation residuals on instruments.

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6 Summary and conclusions

Two types of theories predict that reduced pay spread may be productivity enhancing. Tournament theories provide a simple structure, which articulates the point made by theories of incomplete contracts and multi-task agency, that weak incentives can be more effective in inducing desired worker performance than high-powered but dysfunctional ones. Models based on notions of fairness and reciprocity show that fairness concerns a may act as a constraint on firms wage setting behaviour, and thus, increases in pay dispersion may be counter-productive. Both tournament models and tastes for prize skewness are consistent with skewness effects on productivity. A number of predictions arise regarding individual and collective incentives, and this paper tests these empirical implications together for the first time. Our analysis differs from previous ones in that we consider the entire pay distribution of firms. This is informative in that the burden of proof is greater and potentially theory is more seriously evaluated if in the same general setting both presence and absence of effects can be tested. In other words, tournament-like compensation structures are expected to have certain effects for some groups and different effects for others. The cuts in the data we have chosen which test a number of predictions common to competing theories of tournaments, fairness and tastes for skewness are between managers, non-managerial white collar workers and blue collar workers; and single- and multi-plant firms. Those which distinguish tournaments are collective productivity versus individual effort. The application is to a longitudinal matched employer-employee dataset comprising the population of Danish medium-to-large private sector firms. This together with the nature of the Danish tax system, provides exogenous contract variation required to identify the effect of moments of the pay distribution on productivity and effort. The results of our empirical analysis can be briefly summarised as follows: In common to all theories, for white collar workers, pay spread and skewness are found to increase firm productivity up to a point, after which it becomes counter-productive. Among white collars, counter-productive behaviour is more important higher up in hierarchy. Only weak productivity effects are detected for blue-collar workers. More pay spread and skewness is productive in multi-plant compared to single-plant firms. However, importantly, there are no counter-productivity effects on individual effort. Individual effort is increasing with pay spread and skewness, which is a distinctive prediction of tournament models. The novelty of this paper has been to examine firm productivity and individual effort effects of the whole pay distribution of firms. Differences in firm productivity effects between occupational groups and types of firms give support to theories of fairness, tournaments and tastes for skewness. Only individual effort effects, proxied by

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absenteeism, support tournament theory alone. A more convincing test would require isolating predictions exclusive to fairness and skewness models not in common with tournaments. Rejecting those predictions would base tournament theory on still firmer empirical ground.

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