Organizational Identity and Performance in Compensation Contracts: Theory and Evidence

Abstract

This study explores the effect of employee organizational identity on developing effective compensation contracts to improve organizational performance. We adopt the economic identity theory to mathematically model and test this model using data from a Japanese listed firm that uses an exogenous, uniform incentive scheme based on a seniority system. Situating low-level sales managers as agents and department managers as principals in the mathematical analysis reveals that when organizations do not set optimal compensation contracts, the expected utility of department managers is not high — even if they have high levels of organizational identity — because utility depends on the magnitude of incentive coefficients. Empirical results show that the coefficient of organizational identity has a significant positive relationship with organizational performance. However, surprisingly, when the incentive coefficient is high, the relationship between organizational identity and performance is negative. These results indicate that organizational identity is a “double-edged sword” in incentive schemes with a seniority system, and managers should tune their targets and incentive schemes more finely to optimize firm performance.