Governance and transaction cost theory

Transaction cost theory can be viewed as part of corporate governance and agency theory. It is based on the principle that costs will arise when you get someone else to do something for you .e.g. directors to run the business you own.

Transaction cost theory

Context - the "make or buy" decision

Transaction cost theory (Wiliamson) was first discussed in the context of the decision by a firm whether to do something in-house or to outsource.

Organisations choose between two methods of obtaining control over resources:

• the ownership of assets (hierarchy solutions – decisions over production, supply, and the purchases of inputs are made by
  managers and imposed through hierarchies) and
• buying in the use of assets (the market solution – individuals and firms make independent decisions that are guided and coordinated by market prices).

The decision is based on a comparison of the "transaction costs" of the two approaches. Transaction costs are the indirect costs (i.e. non production costs) incurred in performing a particular activity, for example the expenses incurred through outsourcing.

When outsourcing, transaction costs arise from the effort that must be put into specifying what is required and subsequently coordinating delivery and monitoring quality.

High transaction costs for outsourcing may suggest an in-house solution whereas low transaction costs for outsourcing would support the argument to outsource.

Governance

Transaction cost theory can be applied to a discussion of governance by viewing it as as an alternative variant of the agency understanding of governance assumptions. It describes governance frameworks as being based on the net effects of internal and external transactions, rather than as contractual relationships outside the firm (i.e. with shareholders).

Transaction costs

Transaction costs will occur when dealing with another external party:

• Search and information costs: to find the supplier.
• Bargaining and decision costs: to purchase the component.
• Policing and enforcement costs: to monitor quality.

The way in which a company is organised can determine its control over transactions, and hence costs. It is in the interests of management to internalise transactions as much as possible, to remove these costs and the resulting risks and uncertainties about prices and quality.

For example a beer company owning breweries, public houses and suppliers removes the problems of negotiating prices between supplier and retailer.

Transaction costs can be further impacted by the following:

• Bounded rationality: our limited capacity to understand business situations, which limits the factors we consider in the decision.
• Opportunism: actions taken in an individual's best interests, which can create uncertainty in dealings and mistrust between parties.

The significance and impact of these criteria will allow the company to decide whether to expand internally (possibly through vertical integration) or deal with external parties.

 The variables that dictate the impact on the transaction costs are:

• Frequency: how often such a transaction is made.
• Uncertainty: long term relationships are more uncertain, close relationships are more uncertain, lack of trust leads to uncertainty.
• Asset specificity: how unique the component is for your needs.

Internal transactions

Transaction costs still occur within a company, transacting between departments or business units. The same concepts of bounded rationality and opportunism on the part of directors or managers can be used to view the motivation behind any decision.

The three variables given above can be applied to all behaviour by managers:

• Asset specificity: amount the manager will personally gain.
• Certainty: or otherwise of being caught.
• Frequency: endemic nature of such action within corporate culture

The degree of impact of the three variables leads to a precise determination of the degree of monitoring and control needed by senior management.

Possible conclusions from transaction cost theory

• Opportunistic behaviour could have dire consequences on financing and strategy of businesses, hence discouraging potential investors. Businesses therefore organise themselves to minimise the impact of bounded rationality and opportunism as much as possible.
• Governance costs build up including internal controls to monitor management.
• Managers become more risk averse seeking the safe ground of easily governed markets.

Transaction cost theory versus agency theory

Transaction cost theory and agency theory essentially deal with the same issues and problems. Where agency theory focuses on the individual agent, transaction cost theory focuses on the individual transaction.

• Agency theory looks at the tendency of directors to act in their own best interests, pursuing salary and status. Transaction cost theory considers that managers (or directors) may arrange transactions in an opportunistic way.
• The corporate governance problem of transaction cost theory is, however, not the protection of ownership rights of shareholders (as is the agency theory focus), rather the effective and efficient accomplishment of transactions by firms.

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Tags:	Transaction cost theory;agency theory;Transaction costs;asset specificity;bounded rationality;opportunism