When do firms invest in corporate culture?

Corporate culture receives a lot of coverage in the media and in business courses. It’s a relatively hard to define concept, so it’s not easy to do research on it in a rigorous way. Many questions could arise about corporate culture, one that comes to my mind is whether it’s all just PR, or it really has some kind of an effect on corporate performance.

Let us define corporate culture as creating common goals/aspirations for all employees, and aligning these goals with those of the firm. If this is the case, then it is not hard to see how corporate culture can be useful. But do investments in culture always pay off? Or does it depend on the nature of the industry a firm is operating in?

These questions are investigated by Hiller and Verdier (2014) (ungated version). The basic idea is as follows. Suppose firms compete on two dimensions: (1) they compete on the product market with other manufacturers/providers of the same goods/services, (2) and they also compete on the managerial labor market for managers. Basically, what Hiller and Verdier show is that the toughness of competition on these two markets can incentivize firms to invest or not to invest in corporate culture.

To see this, consider a model where firms can hire managers, and decide how to remunerate them. They can give them a salary, which depends on their performance, and they can also decide to invest in corporate culture. If they invest in corporate culture, then the manager becomes identified with the company, and they will be happy whenever the company is happy, i.e. whenever profits are high.

Now, profits are determined by the effort of the manager. If the manager puts in low effort, profits are lower and vice versa. Of course, managers would rather not waste their time on high effort (it costs them utility). So wage incentives are put in place: if profits are high, the manager will earn more.

This is nice, but even if the manager puts in high effort, there is a possibility that profits will be low, and the manager will thus have a low wage. Putting in a high effort therefore does not guarantee a higher income. There is some income risk if wage remuneration is used. For this reason, firms can also invest in corporate identity. This means that the manager identifies with the firm: he will be happy to put in a high effort.

This utility derived from identifying with the firm can replace wages to a certain extent. But the key idea here is not to replace wages, because investing in corporate culture also costs money. It is that using corporate identity as a form of remuneration instead of higher wages reduces the aforementioned income risk that wages come with.

But why is this worth it for the firm? Well, if the managers have a high reservation wage, then the wage remuneration in case of high profits can be quite high. And this can be very expensive for the firm, so they can actually save a lot by investing in corporate culture.

The figure below illustrates this schematically. The horizontal axis is the reservation wage (utility) of the manager, the vertical is the profit difference between high and low efforts.

Corporate culture: optimal incentive schemes

If the returns to high effort are low, then firms won’t really incentivize high effort (O-region). In this case, the firm offers the same wage regardless of whether profits are high or low, and there is no corporate culture investment. If returns to high effort are high, then the firm finds it optimal to incentivize high effort. For lower levels of reservation wages (P-region), they will prefer wage remuneration. For higher levels of reservation wages (I-region), they prefer investing in corporate culture for the reasons outlined above.

The authors then take this model and put it in an equilibrium framework. They show that there are three possible equilibria in a market with many competing firms: (1) no firm incentivizes high effort (O-equilibrium), (2) firms provide monetary incentives for high effort (P-equilibrium), (3) firms also invest in corporate identity (I-equilibrium). In addition, there is a limited region which is a mix between O and P, i.e. some firms incentivize with wages, others don’t.

What’s interesting is that which equilibrium we are in is determined by the relative sizes of the product market on which the firms are competing, and the managerial labor market where the firms are competing to attract managers.

In particular, if the product market is small in size (low demand for the industry’s product) relative to the managerial job market, then managers are cheap and easy to get. Also, as the product market is small, it is easy for competitors to satisfy the demand, and so the profit differential between high and low efforts is low. So in this case no incentives are provided.

As the product market’s size grows (leaving the managerial market size constant), at some point it becomes worthwhile to incentivize high effort. While the product market is not much larger than the managerial market, managers will stay relatively abundant, so their reservation wages will be moderate. Thus investing in corporate identity will not yet be useful. If the product market grows even further, managers will be relatively scarce and their reservation wages will increase. This – as explained above – will make it optimal for firms to invest in corporate culture.

An interesting point is that if the product and managerial market sizes increase by the same proportion, then there will be two effects:

  1. The increase in the managerial market will make competition relatively more intensive in the product market, which will lower the profit differential (between high and low effort), which will lower incentives.
  2. The increased competition on the product market will, however, push prices down and increase demand on the product market. This will have the opposite effect: larger profit differential, more incentives for managers.

It can be shown that the second effect outweighs the latter: on net a proportional increase in both market sizes provides more more incentives for firms to induce high managerial effort.

This also shows that if an industry’s market (both product and managerial) becomes bigger (say via globalization), then we should see more corporate culture investments from firms.

Another conclusion is that industries where product markets are rising fast (e.g. tech) should see relatively more investment in corporate culture, whereas industries where the pool of available managers is rising fast (e.g. finance?) should have more monetary incentives.

Thus we can see that economic theory can provide some interesting insights into the world of corporate culture. This paper provides quite a few ideas for future empirical research. Nevertheless, it will be rather hard to follow up on these predictions given how difficult it is to measure and operationalize an intangible concept like “corporate culture”.

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