Polytechnic University of the Philippines – Graduate School

Sta. Mesa, Manila

Economic Theories in
Organization
(Organizational Economics)

Vael, Amira Jane F.

Masters of Science in Industrial Engineering and Managemet

Dr. Adrean Manalo

July 2018
I. Organizational Economics
It uses applied economics in understanding how organizations behave and
perform (Financial Glossary, 2016). Organizational economics inherits the use of
economic logic and methods to understand the existence, nature, design, and
performance of organizations, especially managed ones (Őnday, 2016). It does
not only concern relationships within the organization but also in between
organizations.

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 (Sons, 2015).

It studies coordination and motivation of human activities in organizations,

identifies organizational options with their costs and benefits, and underlines
organizational efficiency with implications for the organization of transactions.

There are three major subfields of Organizational Economics.

II. Agency Theory

It is also known as Principal – Agent Approach. Agency theory is concerned with

resolving problems that can exist in agency relationships due to unaligned goals
or different aversion levels to risk (Agency Theory). With owners as the Principal
and corporate managers as Agents.

According to theorist Stephen Ross, “A dilemma in terms of a person choosing a

flavor of ice-cream for someone whose tastes he does not know.”

This theory basically demonstrates conflict of interest between managers and

owners.

A. Issues in Agency Theory

1. Moral Hazard
Principal: I will give you a budget of Php 100M for this project.
Agent: This project plan may be risky but it’s alright. It would be the
burden of the owner.
 In this issue, agent takes more risks because someone else (principal)
bears the cost of those risks. This may occur once either the principal
or agent deviates from the agreed financial transaction.

2. Conflict of Interest
Principal: I need a new building as the company’s extension.
Agent: Hey, sis. I’ll hire you as a contractor for my boss’ new building
project. I’m allowing you to use sub-standard materials.
 Principals commonly delegate decision-making authority to the agents.
Because contracts and decisions are made with third parties by the
agent that affect the principal, agency problems can arise, especially
 when personal interest of the agent causes him/her to make decisions
for the benefit of the third party.

With all these issues at hand, it can cause the principal an Agency Cost -
deviation from the principal's interest by the agent.

3. Agency Costs
a. Costs Caused by Agent’s Own Benefit
b. Costs of Techniques to Solve Agency Theory

B. Countermeasures
1. Contracts
 Contracts include bid documents wherein requirements of Principal is
indicated such as costs, expected output, expected methodology.
 This type of documents assures that Principal and Agents reached to
an agreement wherein if one deviates from the plan, they shall face
legal consequences.
2. Compensation/Incentives
 This does not only limit to money, but also includes mental
compensation such as a tap on the agent’s shoulder, a job well done,
and even a thumbs up.
3. Monitoring
 Daily/Weekly/Monthly reports of agent to principal are suggested to
have an open relationship.
 Principal may also use Performance Evaluation to its agents to monitor
if they managed to achieve their KPIs.

III. Transaction Cost Economics (Theory of the Firm)

Initiated by Coase at 1937 and was defined by Williamson on 1971. This theory
tries to explain why companies exist, and why companies expand or source out
activities to the external environment.

Transaction Cost Economics is a theory of organizational efficiency. It answers

“How should a complex transaction be structured and governed so as to minimize
waste?” (Mikko Ketokivi, 2017).

Transaction Cost Economics is a central theory in the field of Strategy. It

addresses questions about why firms exist in the first place (i.e., to minimize
transaction costs), how firms define their boundaries, and how they ought to
govern operations (Salomon, 2009).

It is theory that states that the goal of an organization is to minimize the costs of
exchanging resources in the environment and the costs of managing exchanges
inside the organization (Bakiev, 2012).
 A. Types of Transaction Costs
1. Internal Transaction Cost
 When transactions occur within an organization, the transaction costs
include managing and monitoring personnel, procuring inputs, and
capital equipment.
2. External Transaction Cost
 It is the transaction costs of buying the same good or service from an
external provider. It includes the costs of source selection, contract
management, performance measurement, and dispute resolution.

Figure 1. Illustration of Internal and External Costs

Figure above shows that when the external transaction costs

are higher than the internal transaction costs, the company will grow.
If the external transaction costs are lower than the internal
transaction costs the company will be downsized by outsourcing, for
example.

B. Factors Affecting Transaction Costs

1. Environmental Uncertainty
2. Opportunism
3. Risks
4. Bounded Rationality
5. Core Company Assets

IV. Contract Theory

Contract theory, coined by Kenneth Arrow on 1960s, is the study of the way
individuals and businesses construct and develop legal agreements. It analyzes
how parties with conflicting interests build formal and informal contracts
(Contract Theory).

Contracts are made due to situations with uncertain conditions, unknown factors
and information asymmetry. It studies the design of formal and informal
agreements that motivate people with conflicting interests to take mutually
beneficial actions (Li & Kolotilin, 2016).

A. Three Models of Contract Theory

These models define the ways for the parties to take appropriate actions
under certain circumstances stated in the contract (Contract Theory).

1. Moral Hazard Model

 In this model, the information asymmetry involves one party’s inability
to observe and verify the action of the other party. It is applied when
performance-based contracts are agreed upon by employers and
employees and actions that are observable and confirmable.

Countermeasure: Employee performance contracts - which depend on

observable and confirmable actions, to serve as incentives for parties to
act according to the principal’s interest.

2. Adverse Selection
 Involves a situation where one party purposely hide certain
information from the other party at the time the contract is agreed
upon.

Countermeasure: Policy regarding parties who withholds valuable

information stated in the contract.

3. Signaling Model
 It is when one party presents all necessary knowledge and
characteristics about itself to the principal. In economics, it is the
transfer of information from one party to another. The purpose is to
achieve a mutual satisfaction for the agreement to occur.