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Agency theory and transaction cost theory

AGENCY THEORY REVISITED

Agency relationships are caused when a principal employs someone (the Agent) to do something for them.
The potential problem is that the Agent may not act in the best interests of the principal:

  • They might simply not perform the task to a high enough standard.
  • They might perform the task for their own advantage.
    A number of agency relationships involving accountants can exist:
  • Shareholders employ Directors as agents to run companies for them.
  • Shareholders employ Auditors as agents to check the truth and fairness of the published Financial Statements.
    The potential for agency problems in companies has increased in recent years because:
  • As companies have become larger / global, the gap between the directors and the shareholders has increased, increasing the chance that directors do not act in shareholder interests.
  • Recent corporate disasters have reduced the level of trust in company directors.
  • Even the largest shareholders have relatively small shareholdings, making it difficult for any shareholder to get enough support (in terms of % of votes) to achieve change.

 

TRANSACTION COST THEORY

In the 1930s, economist Ronald Coase was investigating the reasons why companies exist, and why they were growing so large.

Example:

You have left your job, and have decided to run accountancy exam training courses on your own. You have identified 2 different ways of going about the organisation of your venture:

Option 1

You will either buy a property, or agree a 5-year lease. You have identified 6 tutors who could teach all of the exam papers between them, so you would offer each of them a full time job with salary, pension scheme, health care benefits. Each tutor would have a contract of employment with a 6-month notice period.

You have found a company who publish the text books and other course materials that you need. You would agree a 2-year supply deal with this company.

In each classroom, you will have installed computer and projection equipment which you would buy. You would also buy the necessary chairs and tables for students.

To help finance this plan, you will take out a 5-year bank loan.

Option 2

You will rent hotel conference rooms for courses. For each course, you will book the room 2-3 days before the course once you are sure that the course will run.

You will employ tutors on a freelance basis, only giving them a firm commitment for each day of teaching at the same time that you book the rooms.

For each course, you will shop around publishing companies for the best deal on course materials.

The necessary IT and projection equipment will be hired on a daily basis, although some hotel rooms have this equipment installed already.

Discuss the advantages and disadvantages with these options.

 

Answer:

Option 1 seems to have created an organisation, or company. The organisation owns assets, has employees, and has entered into contracts.

Option 2 seems to involve you running operations from your own home. Everything is organised on a daily basis.

Option 2 would not need much of a financial investment. However, it would cause you a lot of stress because:

  • Everything is organised at the last moment possible
  • Tutors and teaching rooms may not be available if they are booked so late
  • IT equipment may not be available at such short notice
  • Getting anything at short notice is likely to involve higher costs
  • The time spent sorting all of these things out on a daily basis would be huge



Option 1 would require a large financial investment – but it would bring you certainty and control.

 

Conclusion:

Option 1 would make the directors’ lives easier, because of the increased certainty. They would know that rooms, tutors, equipment and materials were always available, making it easier to plan ahead.

After the initial set-up and agreement of contracts, the time saving would be immense, allowing them to focus on strategy.

By having contracts, assets etc., the directors have internalised transactions. Since they no longer have to go to external markets, they have increased their control. They have also saved the transaction costs of searching for the best supplier / tutor / building and negotiating a price, as all of these have been tied up in long term contracts.

The result of all of these benefits?

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.

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:

  • 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



Next time you order a pizza, or buy your lunch, or get your hair cut, ask yourself why you usually go back to the same place, and get the same product as you did last time … it is most likely because you were satisfied last time, so feel certain that you will get something that is acceptable this time.

But there may be better options that you have not investigated!

This concept is bounded rationality. You are making decisions without all the necessary information about some of the options … so you go for the option you know best.

The main reason that you might change would be if an alternative option presented itself at precisely the right moment – and even then such opportunism is not something that everyone would go for! Not everyone is willing to give something unknown a try!

 

AGENCY THEORY AND TRANSACTION COST THEORY LINK

Transaction Cost theory suggests that companies will keep growing because directors want to make their lives easier, through improved control and certainty. This links with Agency Theory in 2 main ways:

  • directors seem to be making decisions that are good for them, rather than for shareholders and other stakeholders … the classic agency problem
  • by making companies larger and larger, the gap between directors and shareholders is likely to widen, making it more likely that directors will not know what shareholders want (and making it harder for individual shareholders to have a “voice” due to their small % shareholdings.