Transaction Cost Economics (TCE)
TCE is a theory that explains how firms choose to organize their transactions in order to minimize transaction costs. Transaction costs are the costs of negotiating, writing, and enforcing contracts.
TCE identifies three factors that affect transaction costs:
- Asset specificity: Investments that are specific to a particular transaction or trading partner can create lock-in, making it difficult and costly for one or both parties to switch to a different partner.
- Environmental uncertainty: Uncertainty about future events, such as changes in trade policies, access to input resources, or currency values, can make it difficult to write and enforce contracts.
- Behavioral uncertainty: Uncertainty about the trustworthiness or intentions of a trading partner can also make it difficult to use market transactions.
= When these three factors are present, firms may choose to use non-market forms of governance, such as vertical integration or long-term contracts, to reduce transaction costs.
Agency Theory
Agency Theory is a theory that explains how firms can design contracts to mitigate agency problems. Agency problems arise when one party (the principal) delegates work to another party (the agent). The agent may not act in the principal's best interests if they have different information or risk preferences than the principal.
Agency Theory identifies two main types of agency problems:
- Moral hazard: Moral hazard occurs when the agent takes actions that the principal does not want them to take, because they know that the principal will not be able to observe their behavior.
- Adverse selection: Adverse selection occurs when the agent has different information about their own capabilities or characteristics than the principal does.
Agency Theory suggests that firms can design contracts to mitigate agency problems. For example, firms can use performance-based contracts to motivate agents to act in their best interests. Firms can also invest in monitoring and enforcement to prevent agents from taking opportunistic actions.
How TCE and Agency Theory are Related
TCE and Agency Theory are two closely related theories. TCE focuses on the costs of transacting with other firms, while Agency Theory focuses on the problems that arise when one party delegates work to another party.
Both TCE and Agency Theory suggest that firms should choose the form of governance that minimizes the costs of the transaction or the agency problem.
Examples of TCE and Agency Theory in Practice
- A firm may choose to vertically integrate its production and distribution processes if there is a high level of asset specificity involved. For example, a car manufacturer may choose to own its own dealerships in order to ensure that its cars are sold and serviced in a consistent manner.
- A firm may choose to outsource a non-core function, such as accounting or IT, if it believes that it can get a better deal from an outside supplier. However, the firm will need to design a contract that mitigates the risk of agency problems, such as moral hazard and adverse selection.
- A firm may choose to use a performance-based contract to motivate its employees to work harder. For example, a firm may pay its salespeople a commission on sales. This gives the salespeople an incentive to work hard and sell as many products as possible.
Overall, TCE and Agency Theory are two powerful theories that can help us to understand how firms organize their transactions.
