Internal Versus Market Pay References in Knowledge-Intensive Firms

How do firms balance market competitiveness with internal cohesion when setting employee pay? We examine this question using confidential compensation data on 19 million U.S. employees across 479 firms varying in knowledge intensity. We construct precise pay reference groups: internal benchmarks based on skill-equivalent peers across functions and market benchmarks based on same occupation, skill level, and region at other firms. We find that in low knowledge-intensity firms, pay is equally sensitive to both internal and market benchmarks, whereas in high knowledge-intensity firms, pay becomes decoupled from market forces and aligns with internal benchmarks. Internal pay alignment also increases following chief executive officer transitions that prioritize innovation. These patterns are driven by high-skilled employees in roles requiring complex problem-solving and collaboration. Moreover, firms with greater internal pay alignment generate more patents, including breakthrough innovations. Altogether, our findings reveal that although 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 complex problem-solving and collaboration are important for value creation. Supplemental Material: The online appendix is available at https://doi.org/10.1287/orsc.2024.19959 .