Abstract:

We propose an asset pricing model in which the optimal wage gap between managers and workers increases with managerial skills. In a world with noise traders and short-sales constraints, we show that firms with lower wage gaps should trade at a premium, and the mispricing becomes even stronger if some investors exhibit inequality aversion. Using a unique data set of German firms, we provide strong support for the model’s predictions. The results suggest that pay inequality within firms has important implications for asset prices.