Transaction Cost Economies:

Agency theory deals with the relationship between the owner of a company and its management as the resolution of a conflicts of interests.Shareholders delegate the task of running the business to their managers,but need to ensure that agency costs are minimized.

 

Transaction cost is an economic theory,it is also attempts to explain companies not just as 'economic units',but as an organization consisting of people with differing views and objectives.You need to know a little about transaction cost economics,in order to contract it with agency theory.

 

Transaction cost Economies is most closely associated with the work of williamson(1975,1984) is often viewed as closely related to agency theory.TCE views the firm as a governance structure whereas agency theory views the firm as nexus of contracts.

 

1.Cost of the firm:Production Costs and Transaction Costs:

The operations of a business entity can be performed either through market transactions or by doing the workin in-house.For Example a business entity could hire full time staff or could hire self employed contractors to do work.An entity might sell its finished goods to a retail organization,or it might sell directly to the end consumer.This is firm decision which option they want to choose whether transaction in the market or work in house(itself) it depend on which is cheaper.

 

When the firm does work 'in-house',it needs a management structure and a hierarchy of authority.Senior management are at the top of the hierarchy.According to the theory of transaction cost of economies ,the structure of a firm and the relationship between the owners of a business and its management depends on the extent to which transactions are performed internally.

 

Total costs are defined as the sum of production costs and transaction costs.

1. Production costs are the cost that would be incurred in an ideal economic market to make and sell goods of the firm.In an ideal economic market,production costs are minimised.

2.Transaction costs are additional costs incurred whenever the perfect situation is not achieved.For example.If a company might sell their product on credit,not knowing that the trade receivable become bad debt.

 

Transaction costs are sometimes higher when a transaction is arranged in the market,and they are sometimes higher when the transaction is done in-house.Carrying out activities in-house rather than arranging contracts externally is reffered to as vertical integration.

 

Total cost are minimised when transaction costs are minimised.This should determine the optimal size of the firm and the size of the management hierarchy in the firm.The way in which a company is organized,and the extent to which it is vertically integrated,also affect the control the companyhas over its transactions.

 

The way in which transaction costs are minimised depends on a number of variables.These are described later.

 

As a general rule,it is in the interests of a company's management to carry out transactions internally and not in the external market.Performing transactions internally:

• removes the risks and uncertainties about the future prices of products and about product quality.

• removes all the risks and costs of dealing with external suppliers.

 

2.Assumptions in transaction cost economics(TCE):

TCE theory is based on assumptions that all behavious is rational and that profit maximization is the rational objective of all businesses.TCE changes these assuptions by trying to allow for human behaviour,and the fact that individuals donot always act rationally.

 

Williamson based his theory on two assumption about behavious:

• Bounded rationality and

• Opportunism

 

Bounded Rationality:

According to TCE that human act rationally,but only within certain limits of understanding.This means for example that the managers of a company will in theory act rationally in seeking to maximise the value of the company for its shareholders,but their bounded rationality might make them act differently.Business is very complex and large businesses are much more complex than small businesses.However,in any business there is a limit to the amount of information the individuals can remember,understand and deal with.No one is capable of assessing all the possible courses of action and no one anticipate what will happen in the future.In a competitive market,noone can anticipate with certainity what competitors will do.

 

Playing the game of chess has been used as an example of bounded rationality.The game is very complex,and there are many different possible moves.The actions of the opponent in a game of chess cannot be predicted,so it is impossible to predict what the opponent will do in response to a particular move.The same problem applies to managing a company.It is impossible to predict with certainity what will happen,because there are too many factors and too many possibilities to consider.

 

Williamson was mainly concerned with what happens when individuals reach the boundaries of their understanding because a situation is too complex or too uncertain.He wrote.'Bounds on rationality are interesting...only to the extent that the limits of rationality are reached-which is to say under conditions of uncertainity and/or complexity.

 

When uncertainity is high,or when a situation is very complex,there is agreater tendency to carry out transactions 'in-house' and to have vertical integration.

 

Opportunism:

Williamson also argued that individuals will act in a self-interested way,and,with gulle'.In other words people will not always be honest and truthful about their intentions.Williamson defined opportunism as:'an effort to realise individual gains through a lack of candour or honesty in transactions'.An individual might try to take advantage of an opportunity to gain a benefit at the expense of someone else.

 

Williamson also argued that it is not possible to predict in advance who might act with opportunism or when.However,managers are opportunistic by nature.Given the opportunity,they will take advantage of available ways of improving their own benefits and privileges.

 

In terms of transactions cost economies,a problem with opportunism is that extenal parties such as contractors and suppliers of goods-cannot always be trusted to act honestly.As a result there may be a tendency for a firm to carry out transactions itself,rather than rely on external suppliers.However,there is also a risk that by taking control of transactions internally,managers will have opportunities to take decisions and actions that are in their own personal interests.

 

This self-interest needs to be controlled.When managers act in their own interests,Investors will be discouraged from providing finance to the company.In this respect transaction cost theory has similarities with agency theory.

 

3. The Variables in transaction cost economics:

Williamson argued that there are three factors or variables which determine the extent to which a firm is 'integrated vertically' and does the work itself.These factors are:

• Frequency of transactions

• uncertainity

• Asset specificity.

 

Frequency of transactions:

A firm will never wish to being 'in-house' a service or the production of an item that is very rarely used.Rare transactions will always be arranged in the market with another individual or entity.

 

For example, a company will rarely ever want to establish its own department for management consultancy.This is because the services of management consultants should be required and only rarely,and they can be provided much better by external specialists.The transaction costs of a market transaction are therefore much lower.

 

However, when goods are produced very frequently,or services are used frequently,there is a much stronger case for vertical integration and bringing the work 'in-house' because the transaction costs should be lower.

 

Uncertainty:

As indicated earlier,uncertainity creates problems partly because of bunded rationality.Uncertainity about transactions will affect a decision about whether the transactions should be done in-house or arranged in the market.As a general rule, greater uncertainity makes it more likely that the transactions will be done in-house.

 

Asset Specificity:

Asset specificity refers to assets that are only valuable for a specific transaction.When an asset has only one specific use transaction costs are likely to be reduced by vertical integration.

 

4.Comparison of transaction cost economics with agency theory:

TCE provices a theory to explain how a company develops into the size and structure that it has,and what might make the size and structure change.It assumes that management behaviour is determined by a combination of bounded rationality and opportunism,with the result that managers will act in their own self interests when the opportunities arise.This self-interested behaviour must be controlled. 

 

Agency theory uses the conflict of interests between shareholders and managers to explain the nature of a company and its governance.Managers will often try to increase the size of their company,even though this is not in the best interests of the shareholders,because they benefits personally from growth in the size of the company.

 

Although they are based on different assumptions both agency theory and transaction cost theory support the need  for controls over corporate governance practice.