TRANSACTION COST THEORY

Transaction Costs

Transaction costs are the costs, both financial and non-financial, of entering into transactions. They include the costs of researching your options, a tendering process, negotiating terms, and the stress and lack of certainty that exist until the transaction is completed. 

Transaction Cost Theory

Transaction Cost Theory states that company directors will usually seek to minimise transaction costs. One way of doing this is to sign long term agreements with customers and suppliers, and to hire full time staff and buy the assets you need. Once the assets are bought, the staff are hired, and the various contracts with customers and suppliers are signed, the directors can “relax” knowing that everything is in place to run their business for the foreseeable future. They are “in control” and have removed the much of the uncertainty within their operations.

Another way to reduce transaction costs is to avoid researching other options when a contract needs to be renewed, or an asset replaced, and to simply repeat whatever choice was made the last time – “go with what you know”, assuming that last time worked out ok. 

One of the reasons why the theory takes this view is that typically directors are running a company that is owned by someone else, the shareholders. It could be argued that the stress and uncertainty is not an attractive option to directors who will not benefit much from the extra effort being put in. 

The concern is that directors are taking the “easy option” rather than pushing harder for the best possible result for shareholders. 

Define “Agency Risk” and explain how it is linked to transaction cost theory

Agency risk is created when principals (e.g. shareholders) appoint agents (e.g. directors) to do things for them, the risk being that the agents do things in their own best interests instead. 

In transaction cost theory, the directors try to avoid uncertainty and stress along with other transaction costs. But this may mean that the company is missing out on last minute opportunities, or is failing to identify other options that are significantly better than their current choices. By making their own lives easier, shareholders may be losing out. 

The problem is worsened by the fact that companies that buy all of their assets, hire full time staff, and enter into long contracts (to avoid the annoyance of constantly renewing them) then need buildings to store the assets and house the staff, maintenance departments to service the assets, HR and payroll departments to look after their staff, IT departments to service their computer systems and all sorts of other support departments, resulting in the organisation growing rapidly in size. As the company expands, the gap between the board and the ever-growing number of shareholders widens, increasing the chance that directors fail to act in shareholder interests (i.e. increasing agency risk).

On top of this, in big companies even the largest shareholder may own less than 5% of the shares, making it very difficult for any one shareholder to have a loud enough “stakeholder voice” to ensure the board understand that shareholders are not getting what they want.