Organizational Economics

What Is Organizational Economics?

Organizational economics is a branch of applied economics and New Institutional Economics that studies the transactions occurring within individual firms, as opposed to the transactions that occur within the greater market. Organizational economists study how economic incentives, institutional characteristics, and transaction costs influence the choices made within firms and the structure and market performance of firms.

Organizational economics can include theories from several different streams of economic thought. These include agency theory, transaction cost economics, contract or property rights theory, theories of the firm, strategic management studies, and theories of entrepreneurship. Theory and research in organizational economics often incorporate insights, concepts, and methods from disciplines other than economics, too, including psychology and sociology. Courses in organizational economics are usually taught at the graduate or doctoral level.

Key Takeaways

  • Organizational economics is used to study transactions within individual firms and determine management approaches to managing resources.
  • It can involve a wide variety of ideas and theories including agency theory, transaction cost economics, and property rights theory.
  • Insights from organizational economics provide a method for causal analysis of critical motivations and decisions in an organization.

Understanding Organizational Economics

Organizational economics is useful in developing a firm's human resource management policies; determining how a firm should be organized; analyzing the size, scope, and boundaries of the firm; setting appropriate compensation, pay, and incentives; assessing business risk; and making, analyzing and improving management decisions.

Popular approaches among organizational economists include:

  • Agency theory: Studying the implications of information asymmetries between owners, managers, and employees of businesses.
  • Transaction cost economics: Studying the role that transaction costs such as information costs, bargaining costs, contract enforcement costs, and relationship-specific investments play in organizational structure and decisions.
  • The property rights approach: Studying the distribution of decision rights based on the incompleteness of contracts within and across organizations.

Organizational Economics and the Deepwater Horizon

Applying organizational economics can reveal both the weaknesses of a current management approach and ways to effect change. Looking at the subfields that comprise this method offers a way to understand the motivations and decisions that lead to operational decisions within an organization. For example, organizational economics could be used to assess why the 2010 BP oil spill in the Gulf of Mexico was able to occur and how a similar disaster could be prevented in the future.

For instance, drawing in the agency theory subfield, an assessment can be made about the incentives that were in place prior to the 2010 BP oil spill, what drove those choices leading up to the incident, and whether the agents involved felt compelled to operate under those conditions. Furthermore, there can be an examination of why the principals at BP may or may not have been aware of the issues and motivations at play with the agents on the oil rig.

Under the transactions cost economics subfield, an assessment could be made about any transaction costs that might have been made regarding the safe operation of the Deepwater Horizon oil rig and how those choices may have affected the disaster. In this incident, information about the safety and risks of the operations were a factor and the transaction costs of communicating the relevant information between BP and the rig operators may have contributed to the disaster.

Applying the property rights theory subfield, the necessary incompleteness of the relations within BP and between BP and the contractor operating the rig may have played a role. The incompleteness of contracts means that someone has to exercise discretion to decide in matters that are not specified in a contract, so residual control and decision rights matter quite a bit. How these decision rights were distributed and how that distribution matched up with information and incentives of the various players may have played a role.