Performance Pay, Union Bargaining and Within‐Firm Wage Inequality*

Theory predicts that performance pay boosts wage dispersion. Workers retain a share of individual productivity shocks and high‐efficiency workers receive compensation for greater effort. Collective bargaining can mitigate the effect of performance pay on wage inequality by easing monitoring of common effort standards and group‐based pay schemes. Analyses of longitudinal employer–employee data show that the introduction of performance‐related pay raises wage inequality in non‐union firms, but not in firms with high union density. Although performance‐related pay appears to be on the rise, the overall impact on wage dispersion is likely to be small, particularly in European countries with influential unions.