Will Diverse Human Resources Be a Plus to Business Performance?

TSURU Kotaro
Faculty Fellow, RIETI

Prime Minister Shinzo Abe created a post of minister in charge of women's empowerment, in reshuffling his Cabinet. On September 12-13, 2014, the World Assembly for Women was held in Tokyo, bringing together representatives of the government and the business community to discuss ways to create a society where women can play an active role. The promotion of women's participation in the labor force and management has now become a pressing policy issue in Japan. However, discussing the significance of women's participation and empowerment solely from the perspective of equal opportunities is not sufficient. In this article, I would like to take a broader perspective and discuss what effects the diversity of firms' employees and managers has on business performance.

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Diversity can be divided into two broad categories. One is diversity in human capital such as education and skills. Complementary knowledge and spillovers resulting from the presence of people with different educational backgrounds and skills will help create new ideas and may lead to improved productivity.

In contrast, diversity in demographic attributes such as ethnicity, age, and gender tends to cause high communication costs, distrust, and weak ties, thereby impeding knowledge spillovers and exchanges.

Such costs would be particularly high in the case of ethnic diversity. However, productivity could increase if the presence of people with different cultural backgrounds brings in varied perspectives, useful ideas, and problem-solving capabilities, thereby enabling the utilization of a greater pool of knowledge. Likewise, age diversity could also create complementarity in human capital because people in different age groups have different sets of knowledge and experience.

Using data on employees of 1,648 Danish firms at a point in time, a 2011 paper by Aalborg University Associate Professor Christian Richter Østergaard and others examined the impact of employee diversity on innovation. They found that diversity in employees' educational backgrounds and gender has a positive relationship with the likelihood of innovation measured by the introduction of new products, whereas diversity in ethnicity has no significant relationship and that in age has a negative relationship with the likelihood of innovation.

However, this type of analysis needs to use data on multiple points in time in order to remove firm-specific effects. It is also necessary to control for the reverse relation of firms' performance affecting employee diversity (endogeneity concerns).

In consideration of those points, a 2014 paper by University of Lausanne Assistant Professor Pierpaolo Parrotta and others, which also used firm-level employees' data in Denmark, showed that diversity in ethnicity has a positive impact on the likelihood of innovation measured by firms' patenting activity. On the other hand, their analysis found that educational (skill) diversity and demographic (age and gender) diversity have no significant impact when controlled for other variables or endogeneity. As such, contradictory conclusions were reached in the two similar studies although they employed different analytical methods.

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Meanwhile, how should we consider the effects of diversity in the boards of directors? The monitoring of managers is what economists focus on as a key role of the boards of directors. In that context, the introduction of outside directors can be interpreted as a move to strengthen the monitoring function by means of greater diversity. However, if diversity in human capital and demographic attributes has any impact on firms' performance, a broader scope of roles played by the boards of directors needs to be considered. Their role as an advisor to managers is what business management scholars focus on.

As is the case with employees, diversity in backgrounds and experience provides the boards of directors with different perspectives, problem solving methods, and access to diverse information, thereby enabling them to offer better advice. Also, board diversity could have potential incidental external effects. For instance, the demonstration of commitment to promoting women and foreign nationals has the effect of increasing their incentive to work harder.

Furthermore, depending on the firm, particularly in the case of those dealing in consumer products, greater board diversity could lead to improved social image, enabling firms to obtain justification from the public, media, and government. At the same time, they could also expect to improve their relationships with investors.

However, there is no denying that greater board diversity tends to lead to interpersonal conflict, lack of cooperation, and insufficient communication among board directors. This could pose a serious problem particularly when outside directors try to obtain information from managers. Also, if firms press forward to introduce board diversity unduly, they could end up choosing directors with little experience or inadequate qualifications, or it could result in an increase in the number of cases where certain individuals serve as board directors of multiple firms concurrently.

Although many studies have been conducted on the relationship between board diversity and firms' performance, their findings do not necessarily warrant a definite conclusion on the relationship between the two, due partly to differences in the analytical methods employed as is the case with employee diversity.

Taking such arguments into account, a 2010 paper by London School of Economics Professor Daniel Ferreira warns against using the presence of a positive or negative relationship between board diversity and firms' performance as evidence in arguing whether or not to introduce greater board diversity. Instead, he argues that analytical findings in the studies hitherto conducted on board diversity should be taken as evidence showing that there are both costs and benefits of having greater board diversity.

A 2011 paper by American University Professor Ronald Anderson and others showed that a composite index of board diversity, which was constructed from six diversity measures—i.e., educational, professional, experience, age, gender, and ethnic heterogeneities—by controlling for firm-specific effects and endogeneity concerns, has a positive relation with firms' performance such as Tobin's q (market value to replacement value ratio), but the degree to which firms benefit from greater board diversity varies depending on their characteristics. Although firms with complex operations benefit from ever-increasing diversity, those with less complex operations may suffer a negative impact. In particular, they showed that diversity in human capital such as occupational backgrounds and experience has a greater impact on firms' performance than diversity in demographic attributes such as gender and ethnicity.

From the above, we can see that board diversity requirements should not be imposed uniformly across all firms. And if board diversity is to be promoted, it is crucial to provide an environment that allows for the maximization of its benefits.

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Then, what sort of environment is needed to promote women's participation, which is a type of diversity that is attracting the greatest attention at present. In a 2014 paper, Harvard University Professor Claudia Goldin focused on the gender wage gap and analyzed what factors explain the last remaining gap, which continues to exist despite the significant gender convergence over the years in education and experience.

What has become apparent is that women's difficulty to fulfill temporal demands—i.e., working at particular hours or timing critical to the firm, working long hours to be readily available at any time, etc.—due to childrearing and other duties is a significant factor. This tendency is particularly conspicuous in the areas of financial and legal professionals. Professor Goldin argues that the "last chapter" for the elimination of the gender pay gap is to redesign the ways in which jobs and pay systems are structured so as to allow for greater flexible work hours.

If we translate this into the context of the ongoing discussion in Japan, flexible work hours could be deemed to have been secured by introducing a full-time permanent status with limitations in work hours and creating a system that allows employees to switch freely between such status and the conventional full-time permanent status according to the stage of their life cycle.

Initiatives designed to promote women's participation would not yield any significant results so long as the scope of their target is confined to women. Changing Japan's conventional employment system, where those working long hours and being available at all times on call are highly appreciated, is what is needed most now in order to create a "society in which women shine."

>> Original text in Japanese

* Translated by RIETI.

September 22, 2014 Nihon Keizai Shimbun

October 31, 2014