Using a unique dataset with administrative information on over two million matched employer/employee-year observations in Italy over the 1994-2000 period, we examine the causal effect of a quasi-exogenous shock to within-firm pay inequality on firm performance. Consistent with the fair wage-effort hypothesis, pay dispersion increases among firms whose workers show lower sensitivity to pay inequality. These firms outperform similar firms whose workers show higher sensitivity to pay inequality. Our results unveil a shadow cost of relative wage concerns for firms and the potential adverse effects of imposing an ad hoc limit on firms’ pay dispersion.

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