Firms face significant constraints in their ability to differentiate pay by worker productivity. We show how these internal equity constraints generate a quantity-quality trade-off in hiring: firms which offer higher wages attract higher skilled workers, but cannot profitably employ lower skilled workers. In equilibrium, this results in workplace segregation and pay dispersion even among ex-ante identical firms. Our framework provides a novel interpretation of the (empirically successful) log additive AKM wage model, and shows how log additivity can be reconciled with sorting of high-skilled workers to high-paying firms. It can also rationalize a hump-shaped relationship between firm size and firm pay, and provides new insights into aggregate-level, regional and sectoral variation in earnings inequality - which we explore using Israeli administrative data.

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16 March 2026     Paper Number CEPDP2161

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This CEP discussion paper is published under the centre's Labour programme.