Organizational economics – definition and meaning

Organizational economics uses applied economics to understand how organizations behave and perform. Organizational economics also tries to understand the design and nature of organizations, especially companies. It is an applied economics theory that studies the transactions within an organization versus those between different organizations.

Applied economics involves understanding economic theories and trying to put them into practice.

We also use the term economics of organization with the same meaning as ‘organizational economics.’

Organizational economics focuses on a company’s organizational structure, compensation, incentives, pay plans, risk management policies, and management decisions.

In these organizations, we look at how decisions are made and how people handle disagreements. This helps us figure out the best ways to run the organization and make it work well.

Put simply; organizational economics is the study of how we create and develop institutions and how they affect growth.

Organizational economics – three subfields

We break down the economics of organization into three principal subfields: contract theory, transaction cost theory, and agency theory.

  • Transaction cost theory

Transaction cost theory refers to the costs involved in organizing an activity. Specifically, costs regarding bureaucracy, communication, and research of information. A transaction cost is a cost we incur when making any economic trade.

In other words, when we trade it costs money.

Economists divide transaction costs into bargaining, policing and enforcement, and search and information costs.

Organizational Economics - definition and subfields
According to Wikipedia, “Organizational economics is primarily concerned with the obstacles to coordination of activities inside and between organizations.”
  • Agency theory

Agency theory looks at the dilemmas there are when we make decisions on behalf of another entity. We also call it the principal-agent approach.

Agency theory also looks at the impact of those decisions. The entities may be people, companies, or organizations.

Agency theory looks at how problems arise because of differences between the different players in the economy or within a company.

For example, senior management may want to expand into other markets. This means short-term profitability will suffer so that the company can grow more rapidly later on.

However, the shareholders, who may be unaware of these plans, want higher profits now. In other words, the shareholders want jam today while the senior management wants jam tomorrow.

What will happen if senior management goes ahead with its plan, but the shareholders do not know? There will be a problem.

  • Contract theory

Contract theory studies how we construct contractual arrangements. In most cases, we make these arrangements with asymmetric information. Asymmetric information exists when one person in a contract or negotiation has more information than another.

Economists commonly categorize contract theory within a field we call Law and Economics.

According to an essay by Robert Gibbons, from MIT, and John Roberts, from Stanford University:

“Organizational economics applies the theoretical and empirical methods of economics to study the nature, roles and performance of organizations, especially managed ones like business firms.”

The above quote comes from ‘Emerging Trends in the Social and Behavioral Sciences,’ John Wiley & Sons Inc. DOI: 10.1002/9781118900772.etrds0244, published online 15th May 2015.

An organization is an organized group of individuals with a common goal. They work together and coordinate their activities.

Video – What is Organizational Economics?

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