The Effects of American- and Japanese-Style Employment and Compensation Practices on Innovation

Success in the global marketplace increasingly requires that firms develop capabilities in innovation. In this paper we argue that firms can use employment and compensation practices to foster innovation and support for innovation by employees. Conversely, some employment and compensation systems will inhibit innovation. A system that allows gain sharing by employees and provides employment assurance will foster innovation in the firm. However, a system that compensates employees with a fixed wage and allows for termination at will contains anti-innovative incentives. The former system is the prototypical Japanese system (particularly in large firms), while the latter system is the prototypical American system. The commercial success of Japanese firms is increasingly attributed to successful innovation, particularly in processes. We argue that this success is partly attributable to the Japanese-style system of employment and compensation. None of this suggests, however, that the Japanese-style practices constitute a universally superior system of employment and compensation. The Japanese-style system will not necessarily be beneficial to firms, nor be preferred by employees. The preferences of both employees and firms will depend upon market circumstances. In stable domestic markets in relatively full employment economies, companies derive competitive advantage from mass production and scale economies. Under such circumstances, the American-style system is likely to be preferred by both employees and firms. However, when the firm operates in a volatile international market the preferences of both employees and firms will shift toward the Japanese-style system. The employment and compensation systems of both countries were well suited to the market circumstances under which they evolved.