The Effect of Merit Pay on Organizational Productivity in Small and Mid-Sized Firms:

Abstract

Since the 1997-98 Asian financial crisis, Korean firms started to change their management systems following practices of large western companies based in North America. One of the major changes was the adoption of a pay-for-performance plan called merit pay. Not only Korean conglomerates but also a few small and medium-sized enterprises have adopted merit pay to survive in the increasing uncertainty inherent in the business environment. But the effects of this practice are controversial even in the home, North America; both the positive and negative theory-driven arguments conflict with each other, a few empirical pieces of evidence have shown insignificant results with respect to a longitudinal aspect. Therefore, I examined the effect of merit pay adoption in the small and medium-sized enterprises on organizational productivity over time after the financial crisis. Theoretically, I took advantage of marginal productivity theory of wages to propose the positive relationship between merit pay implementation and organizational productivity (hypothesis 1). Next, I drew on strength of the HRM system theory in terms of consistency and two psychological theories (i.e., expectancy theory and reinforcement theory) to suggest the effect of merit pay over time (hypothesis 2). In methodology, the first Human Capital Corporate Panel survey conducted in 2005 was the data; among 454 firms, I sorted firms based on two criteria: small and medium-sized enterprises and firms that adopted one of several types of Yeonbong-je, including merit pay, in 2000. The remained samples were 32. I used organizational-level productivity data such as revenue per employee, ordinary income per employee, and net income per employee for four to six years as organizational productivity. I used latent growth modeling to capture the initial status right after the adoption of merit pay, and the changes in organizational productivity. The results showed that adoption of merit pay negatively influenced on organizational productivity after a year from the adoption, i.e., ordinary income per employee and net income per employee, respectively (rejected hypothesis 1). Since then, the increasing linear growth pattern occurred at least for three years (supported hypothesis 2).