When I was an undergraduate student and took my first economics class, I was hooked. But, rather than major in economics, I chose to major in business. That’s because I wanted to understand how the economy worked at its “smallest” unit, which I surmised was the individual business.

Economics can of course study individuals and their decision-making too, but at least on the supply side, I thought that a single business could be considered the smallest unit of the economy.

Economic theory can tell us how firms behave in a perfectly theoretical world…but how do they actually function? This was a question that captured my attention, and I decided to major in business (with a concentration in management consulting) to understand the working world as much as I could.

Before diving deeper, let me state clearly: I don’t believe this is the best strategy that an aspiring economist could take for their studies. If you love economics, it’s much more efficient to simply study economics. Still, my undergraduate degree — and my subsequent experiences working in industry — have given me some valuable perspective about business and economic theory.

In particular, this article shares some largely intangible factors that I think about often when reading (relevant) economics research papers, or thinking about my own future research. I hope that it offers food for thought to current business students who may be thinking about a switch to economics within their current program or for a postgraduate degree.

Without further ado, let’s dive in!

The economically ideal firm: a rarity in reality

When firms are discussed in economic theory, they’re usually depicted as lean, efficient, profit-maximizing entities that adjust rapidly to market conditions. In a similar vein as the ever-present rational economic man, this is good enough for the purposes of learning, and it greatly simplifies the math that economists must perform (without losing important nuance).

Still, from my time in both studying businesses and working in them, I’ve learned and experienced many things that show this isn’t always the case. In fact, I think it’s almost never the case that a firm lives up to the economic ideal of a profit-maximizing machine (a hot take for the Neoclassicals in the room, but perhaps not surprising for the rest of you!). There are many reasons for this, some of which surprised me when I started working for the first time.

Soft skills are hard to measure, but intensely important in the real world

In the world of business, it’s no secret that soft skills are important. Soft skills include the ability to interact well with other coworkers, and importantly to present oneself and one’s work as useful and impressive. An employee who does great work but isn’t very good at making it known, or presenting it well, will appear to be a less effective employee than one with excellent public speaking and self-promotion skills. And employees who are fairly social, work well with others in teams, and handle their own emotions and conflicts professionally will be much more effective than those who do not.

Many of the following points in this article deal with soft skills in some capacity, and as such we’ll move on to those points more specifically. But before getting into the nitty-gritty of the firm itself, it’s worth pointing out that one of the most critically important soft skills can begin before a job even starts: networking.

Business has reinforced how network effects are powerful and must be accounted for

In my experience — and likely very many other people’s — networking is the single most effective way to find a job. I’ve managed to land several jobs through cold applications, but (in most cases) only after sending hundreds of resumes out to potential employers, the majority of which received no response. For many, networking seems to be the only ray of hope in a sea of automatically rejected applications.

But make no mistake: firms aren’t solely at fault for a difficult job market. Firms usually receive hundreds or even thousands of applications for a single position, a large amount of which may be clearly unqualified. This forces hiring managers to streamline the process of going through applications as much as possible. So, when a current employee recommends an applicant, a hiring manager knows that person is likely to be a quality candidate (as long as the employee is in good standing!) and their application immediately stands apart from the pile.

Networking has several further benefits for both prospective employees and prospective employers. For instance, if a current employee recommends an applicant, it suggests that that prospective employee would likely be a good fit for the firm’s culture as well, which is very difficult to determine beforehand if an applicant is a total stranger. This grants that recommended applicant another advantage over the rest.

Within economics, we have a well-researched concept called “network effects”, which reflect just these kinds of forces — and more. In labor economics, network effects might refer to broader situations, such as immigrant communities helping other immigrants move to and survive in a far-off land (think of, for example, the colonization of the Americas — network effects among European settlers in the first successful colonies made it easier for future settlers to arrive and survive).

Generally, network effects lower the transaction cost for individuals and/or firms to find a suitable match in the labor market. My experiences in the labor market — not to mention casual discussions with a professor of economic history — have specifically emphasized to me how important these network effects can be!

Networking doesn’t merely end once someone is hired, however. Relationships within a firm are often critical indicators of an employee’s long-term success, as well — and this gets to the heart of those critically important, intangible factors present in the business world.

Incentives within firms are often messy and far from the economic ideal

We must recognize that firms are made up of individuals. This simple statement has a large consequence, because individuals face their own set of incentives — and these are almost never perfectly aligned with the firm’s. Still, even though many firms can end up becoming a messy tangle of incentives, these incentive issues are (admittedly) usually insignificant. Employees must perform well enough to retain their paycheck, after all.

Nevertheless, occasionally firm-employee incentive misalignment can lead to costly consequences. It’s easy to find stories in the news about employees who, after being fired, cost the firm large amounts of money — especially in tech (see for example this Infosecurity article). Often these acts of revenge are illegal, and former employees are prosecuted, but this does not reverse the damage the firm suffers. Still, this type of incident isn’t limited to ex-employees.

Consider an employee working for a firm who questions their job security. In such a case, they’d be heavily incentivized to make themselves irreplaceable by any means possible, or simply to aggrandize themselves to make it appear that they were irreplaceable. Again using a tech example, one way an employee can do this is by writing critical code in an unintuitive manner and without using comments (or providing other documentation) to help other developers read it. This artificially and inefficiently increases the cost for a firm to fire this specific employee, and thus artificially increases the employee’s job security at the cost of the firm’s performance. In extreme cases, employees may even be incentivized to sabotage initiatives of the firm in order to maintain their own importance in the firm’s hierarchy.

Inflated CEO/executive pay is another example of misaligned incentives. An individual CEO is heavily incentivized to give themselves as much credit for the firm’s success as possible, and to capture as much of the firm’s profit as they can for themselves (usually in the form of bonuses). This can be mitigated by a firm’s board of directors, who are typically the “boss” of the CEO in a public company, but if the board and the CEO are friendly this check may fail.

Rather than pay the CEO millions of dollars in bonuses each year, it’s likely in the best interest of the company to keep most of that money and reinvest it into the firm’s activities, or even spread it among employees to increase morale or loyalty.

There are many, many more examples of incentive issues that could be discussed here. But the existence of these point to another aspect of human behavior that influences business performance: interpersonal relationships.

Managers and office politics greatly influence productivity

Humans are primates with varied and intricate social dynamics. This can be wonderful…but it also creates a lot of problems for firms.

Office politics are rarely discussed in economics courses (and seldom discussed in business courses, either!), yet they are an omnipresent force that shapes a workplace immensely. Work that would otherwise be a dream job for someone may end up being a nightmare purely because of interpersonal relationships; conversely, a job that someone strongly dislikes might be tolerable thanks to the presence of great coworkers, managers and leadership.

When I first began working, I was shocked at how important “office politics” were. I had thought that simply doing great work would get me noticed. I also expected that managers would be good at seeing through the “surface level” of performance and identifying when employees were doing value-added work, when they were simply looking busy, and when a doomed project made an employee look less productive than they actually were (or vice versa). Yet, this was not the case in my (admittedly subjective!) experience.

Often, employees who stayed later in the office were seen as more productive compared to employees who routinely left at 5PM on the dot. Yet, simple logic would suggest that this is precisely the opposite!

If someone must continually stay late to finish their work, it’s likely that they’re less efficient than other coworkers who leave “on time”, all else equal. Of course, it’s possible that some employees simply have more work to do than others — but staffing is the manager’s job, and thus they should be aware of relative workloads and balance them accordingly.

In several roles, I witnessed that being favored by managers meant that employees’ work was valued and lauded almost without fail. Meanwhile, some disfavored but very hard-working employees went unrecognized. Related to this, managers in multiple roles I held frequently seemed unable to disentangle the performance of employees from the performance of the specific projects they were tasked with.

While it’s true that an employee can make or break a project, it’s also true that some products or projects are simply doomed to failure, while others are “slam-dunks” (a simple proof of this: the failure of Google Glass, which despite parent company Alphabet’s best efforts, simply did not have a viable market. Even the best marketing team in the world likely could not have made it work).

In summary, office politics and evaluations of employees can be closely tied with how managers perceive the work that employees do, rather than the actual quality of the work done. These forces culminated in a founding member of one of my former work departments quitting over unfair treatment, and quickly getting snapped up by a competing firm. It also led to a new employee being promoted twice in the span of 6 months, putting them in a more senior role than other employees with more tenure than them — simply because the project they were on was overperforming (in my opinion, largely due to the sales efforts of that new employee’s very experienced manager). Both situations worsened morale significantly for other employees.

These are admittedly subjective experiences, yet most people who have worked before can likely relate to them. And, people who haven’t worked much before probably have friends or family who have griped about similar situations.

Outside of managerial “politics”, there are many interpersonal relationships that form the work environment which can influence productivity. Some people may not like each other, and therefore may not be effective teammates. Conversely, some people might get along too well, and might experience reductions in productivity because they’re having fun discussing non-work-related items for long periods of time. Sometimes employees even date each other, and later may break up, which can obviously introduce a significant tension into a team.

These inefficiencies can be mitigated by firms in various ways, but are still issues that can take time and resources to deal with. Unfortunately, it’s very difficult to have good information about the true state of interpersonal relationships, for both managers and employees.

Of course, these inefficiencies and internal politics in general are very, very difficult to measure empirically and study.

Employees often have imperfect information about their own firm

The consulting industry is massive, and it’s dominated by the “Big 4”: EY, Deloitte, PwC, and KPMG. These acronym-loving firms offer management consulting services, in which client companies hire them to do a deep dive into specific business problem and pose possible solutions.

Statista shows that the worldwide market size for management consulting services was over $1 trillion in 2023. The fact that this market exists — nevermind that it is so large— shows that firms do not have perfect information. The reason why is simple: if firms had perfect information, they wouldn’t need to hire management consultants!

What’s more, employees — including managers and executives — often have relatively little information about their own firm and its activities. It’s difficult to know what all of your immediate coworkers are doing, nevermind what every other area of the firm is responsible for. In larger firms, employees may be routinely surprised by developments made by other parts of the firm. Some departments may even have goals that are opposed to or incongruent with one another!

From an efficiency standpoint, this may not be as big of an issue as it seems; after all, the job of executives is to guide and direct the firm, and it’s expected that they would have better-than-average insight into the firm’s activities. If a department was underperforming or misaligned, they could shrink, cut, or adapt it. Still, it’s easy to see how the economic ideal of a single profit-maximizing entity might not be realistic due to these factors.

Many economic models have adapted to include situations of imperfect information, as it’s a major factor that economists have recognized for a long time. In fact, models continue to evolve — and if economists deem it relevant and helpful, I expect that many of the topics discussed in this article will continue to be incorporated into research and increasingly intricate and realistic economic models.

Economic models tend to be simplified, but that’s often enough

Despite sometimes having unrealistic assumptions, our general economic theories still work very well most of the time. We’ve previously discussed on the INOMICS blog that economic models, especially when considering their intended purpose, usually do not need extremely realistic assumptions. That argument need not be repeated here.

Still, most of the topics discussed in this article are ripe for future research, and some economic models may benefit from a more comprehensive integration of several of these concepts. Just as labor economists have modeled the frictions in the labor market before, models that take into account the internal frictions of incentives and relationships — and research that aims to estimate how much they cost — will continue to deepen our understanding, and perhaps even help to influence policy.

Behavioral economics, labor economics, firm theory, and game theory are all areas that have touched upon some of these important intangible factors before, and increasingly in recent years. For examples, see this 2023 paper about misaligned incentives between contractors and utility companies; another 2023 paper that details how misaligned incentives can possibly benefit leaders; and yet another 2023 paper discussing how organizational politics affects employees’ engagement.

Yet, these areas remain ripe for future exploration. I suspect that many of the brilliant economists of tomorrow will find ways to deepen our understanding of these areas with their research.

Perhaps, if you find a suitable Master’s or PhD in economics, you might even be one of them!

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