PRINCIPLES OF TRANSACTION COST THEORY

Transaction cost theory originated from the 1930s, when the economist Ronald Coase was investigating the reasons companies exist and why they were growing so large.

Transaction costs are incurred in spending time researching, negotiating and agreeing a transaction. Transaction cost theory examines the theory that directors would rather enter into agreements for their sources of goods and services as this reduces uncertainty as they have everything they need for the foreseeable future. By doing this the time and expense of sourcing materials is avoided.

Coase believed that, on average, directors would prefer to lose the flexibility of searching for inputs in order to have the certainty of predicting what would happen with their business in the future. Whilst committing to long-term agreements and contracts avoids uncertainty and is easier to control, it could mean that better opportunities may be missed.

Coase’s concern was that directors were making their own life easier at the expense of opportunities that would improve shareholder wealth. However, if directors are not concerning themselves with constantly sourcing and renegotiating resources, they have more time to spend on longer-term strategy issues.

Transaction cost theory explains why companies are getting bigger. Transaction cost theory says that in order to reduce uncertainty and to increase control, a company should tie itself up in more agreements and this therefore means more staff, more assets, more contracts and a larger company.

Alternatively, a board of directors who are worried about the security of their supplies may choose to buy the company that supplies them. This is called vertical integration. The downside to vertical integration is that supplies will always come from that one company and there may be better quality or prices to be had elsewhere.

This helps to explain why the agency problem is getting worse. A larger company means the gap between shareholders and directors gets bigger.

In Summary:

1. Directors are likely to prefer to own things, or at least have long-term contracts in place, because it makes their lives easier through increased control and certainty over the future.
2. As such, they are likely to create larger and larger organisations/companies. This may be good for them, but may not result in the best decisions for shareholders or other stakeholders as:

• the organisation may grow larger than is efficient;
• by agreeing long term contracts, the ability to take advantage of good deals in the future may be lost;
• because directors will get to know company staff, assets etc. very well (because they are internal), they may simply renew contracts without looking at outside options.