This document provides an overview of agency theory and transaction cost theory from an economic perspective. It discusses the principal-agent problem, where the interests of the principal and agent may diverge due to information asymmetry or differing risk preferences. This can lead to issues like moral hazard or adverse selection. The document also examines how transaction costs relate to the costs involved in economic exchanges. It explores how agency theory and transaction costs can help explain organizational structures and governance.

1. ECONOMIC FOUNDATION OF STRATEGY:
AGENCY THEORY & TRANSACTION
COSTS
Anuj Vijay Bhatia
Fellow Programme in Rural Management
Institute of Rural Management Anand

2. OUTLINE
 Agency Theory (The Principal-Agent Problem)
 Transaction Cost Theory

3. AGENCY THEORY:
THE PRINCIPAL-AGENT PROBLEM

4. AGENCY PROBLEM: PREAMBLE
 Jensen and Meckling (1976)*
o An agency relationship is a contract under which one or more
persons (the principal) engage another person (the agent) to
perform some service on their behalf which involves
delegating some decision making authority to the agent.
o Agent responds to incentives and will not always act in the
best interests of the principal.
 Agency theory is a theory of governance in the workplace.
 It tries to solve the problem of separation of ownership
(shareholders) and control (professional executives and non-
owners)
 It also tries to solve conflicts of interest between managers and
employees with delegated responsibilities.
*Jensen, M.C. and Meckling, W.H., 1976. Theory of the firm: Managerial behavior, agency costs
and ownership structure. Journal of financial economics, 3(4), pp.305-360.
[This Paper has 76,373 Citations on 18/11/2018]

5. THE AGENCY PROBLEM
 Why does the agency problem arise?
 Separation of ownership from control produces a condition where
the interests of owner(s) and managers often diverge and that
discretionary power by managers exists (Berle, A. and Means, G., 1932.
Private property and the modern corporation. New York: Mac-Millan)
 First, the agency problem arises when:
 (a) Incentives of the Principal and Agent are not aligned
 (b) Information Asymmetry
 Moral Hazard
 Adverse Selection
 Secondly, problem of risk sharing arises when:
 Principal and Agent have different risk preferences
 Principal may be risk-averse but agent may be risk-seeking

6. BASIC SET UP
 Assume that both agent and principal are self-interested,
“rational” and seek to maximize their own utility
 The principal and the agent must agree upon compensation that
is dependent on the output produced, serving as an incentive for
the agent to produce optimal output
 However, the principal observes only the output and hence
bases the compensation on the output and not on the actions of
the agent
 Thus, the agent privately chooses an (output-producing)
action that maximizes his own utility, which is unobservable to
the principal who must reward the agent on the basis of the
output observed
 Principal-Agent models attempt to explain the potential
conflict between the various interested parties.

7. BASIC SET UP
 It is important to note that the principal and the agent
interact (and the agency problem exists) because of
division of labor.
 If there is no division of labor, there is perhaps no agency
problem.
 Even in a Robison Crusoe economy (one consumer and one
producer), there are two actors with division of labor; that are
required to interact and are interdependent
 The P-A Model is therefore applicable to variety of contexts.
 Ultimately, this basic model will explain whether:
 The two parties should contractually enter into the relationship;
and
 If the relationship will work efficiently

8. PRINCIPAL-AGENT FRAMEWORK
 Agency theory involves dealing with contractual issues
relating to asymmetric information, moral hazard,
bounded rationality, and adverse selection.
 Asymmetric information: When one party does not have
complete knowledge of actions or characteristics of the
other party
 Moral hazard: The agency problem that arises when
actions taken by the agent are unobservable to the
principal; (hidden action) actions of the elected
representatives can be observed during certain times
 Bounded rationality: When agents are limited in their
capacities to take decisions based only on the information
available.
 Adverse selection: The agency problem that arises when
some characteristics of the agent are unobservable to the
principal (hidden information)

10. AGENCY PROBLEM: EXAMPLE
 Consider the case of a manufacturer-retailer relationship
referenced in the diagram.
 The manufacturer (principal) must decide whether to sign a
contract with the retailer (agent) who is able to sell the produced
commodities in the retail market.
 The objective of the relationship is to maximize the sale of output
that will benefit both the manufacturer (directly) and the agent
(via margins earned on sales).
 The manufacturer cannot perfectly observe the prices (or price
policy) set by the agent (retailer), but only the revenues. The
retailer in turn expects the manufacturer to produce high quality
goods that are shipped in a timely manner to ensure sales

11. AGENCY PROBLEM: EXAMPLE
 To the extent that revenues are maximized, the
manufacturer continues to produce, and the manufacturer
will produce more if retailer provides information on sales
levels
 Manufacturer capacity to produce is not fully known to the
retailer, therefore she is in the dark about the timing of the
supply of goods
 For example: Maruti solves the agency problem by
opening Nexa showrooms – by assuming both roles of
principal and agent, Reliance markets vegetables
 Farmers can organize themselves to hold a stake in the
retail chain (such as Reliance) and reduce uncertainty
around procurement and reduce information asymmetry to
ensure revenue maximization

12. ADVERSE SELECTION & MORAL
HAZARD

13. ADVERSE SELECTION
 Adverse selection refers to hidden information, where the
‘type’ of agent is unknown to the principal
 Arkelof (1970)* describes the problem of adverse selection in his
paper “The Market for Lemon’s”. Adverse selection is a form of
market failure resulting when products of different qualities are
sold at a single price because of asymmetric information, which
results in too much of low quality product (lemons) and too little
of high quality sales, hence there is an incentive for pre-contract
(ex ante) opportunism which induces adverse selection
 Absence of signaling and failure of job markets could lead to
recruiters not being able to effectively distinguish a ‘good’ hire
from a ‘bad’ one.
 [Akerlof, G.A., 1978. The market for “lemons”: Quality uncertainty and the market
mechanism. In Uncertainty in Economics (pp. 235-251).]

14. MORAL HAZARD
 Moral hazard refers to hidden action, where some
action(s) of the agent are not perfectly observed by the
principal.
 Agent is tempted (and some cases succeeds) in taking
advantage of information asymmetry with principal and
act opportunistically (defined as making decisions not
aligned with principal’s interests) and use the firm
resources to maximize wealth of the agent (often at the
expense of the principal).
 E.g. Shareholders cannot effectively monitor management at
all times, and must base incentives on available information.

15. AGENCY COSTS
 Agency costs are defined as:
 The monitoring costs by the principal;
 The economic bonding costs by the agent;
 The residual economic loss.
 Jensen and Meckling (1976) maintain that agency costs are an unavoidable
result of the agency relationship.
 The contractual relations are the essence of the firm, not only with employees, but
also with suppliers, customers, creditors, and so on.
 Most organizations serve as a nexus for a set of contracting relationships among
individuals.
 Since decision makers ultimately bear the agency costs, these decision makers
have the economic incentive to minimize agency costs.
 Jensen and Meckling (1976) conclude that the level of agency cost depends,
among other things, on statutory and common law, and human creativity in
devising better contracts. Both the law and the sophistication of contracts
relevant to the modern corporation are the products of an historical process
in which there were strong economic incentives for individuals to minimize
agency costs.

16. SOLVING AGENCY PROBLEM
 There are three schemes that the principal can approach
the agent with, each of which come with a cost of
implementation to the principal.
 These include Carrot mechanism, Stick mechanism and
a mix of carrot and stick mechanism.
 Carrot: the agent receives a bonus for high effort, at a low cost
to the principal.
 Offer Incentives and Commissions
 Stick: the agent is fired for low effort, a high cost to the
principal)
o Penalties for the violation of routines
o Limit the management discretionary power
 Carrot and Stick: the agent is given a bonus for a high effort
but is also threatened to be fired if the effort is low, a mix of
low and high cost to the principal

17. COOPERATIVES AND AGENCY PROBLEM*
 Principal-Agent problem: Non-alignment of interest/objectives
 Relations may be defined by contract, but they are incomplete
 Moral hazard and imperfect observability
 Incentive v/s risk sharing trade-off to align interest
 Relevant to institutional structure of cooperatives
 Challenge: Which ownership and capital structure will lower agency
costs.
 Agency problem leads to member dissatisfaction
 Coops experience greater agency problem due to lack of capital
market discipline, a clear profit motive and transitive nature of
ownership.
*[Ortmann, G.F. and King, R.P., 2007. Agricultural cooperatives I: History, theory and
problems. Agrekon, 46(1), pp.18-46.]

18. APPLICATIONS OF AGENCY THEORY
 Accounting
 (Information Sharing)
 Economics
 (Institutional Economics, Cooperatives)
 Finance
 (Capital Markets, Capital Structure)
 Marketing
 (Sales & Distribution, Supply Chain)
 Political science
 (Voter-Elected Representative)
 Organizational behavior
 (Compensation, Incentive Design, Performance Appraisals)

19. TRANSACTION COSTS THEORY

20. PREAMBLE
 What are transaction costs?
 Transaction costs are the costs incurred in making an economic
exchange. It Includes Search and Information Costs, bargaining and
decision costs, and policing and enforcement costs.
 Every exchange involves this cost to different extent influenced by social
institutions (norms of behavior), legal institutions, political institutions and
economic institutions
 It becomes important to understand the role of transaction costs in a
principal-agent relationship, particularly under information asymmetry.
 Coase (1937): Inefficiency of transacting in world of imperfect information
 Contracts are necessary to protect from opportunistic behavior & reduce
Transaction Costs.
 Completeness of contracts also necessary
 Contracts are always incomplete due to bounded rationality and lead to opportunism
and Transaction Costs
 Helps to design the most efficient institutional arrangement for conducting
transactions
 Firms should select those institutional arrangements where the sum of production and
transaction costs are minimum

21. TRANSACTION COSTS THEORY
 In the context of the principal-agent model, there may be a
‘contract’ (agreement) drawn up between the principal and
the agent to ensure that certain goals are met
 A transaction cost may be incurred in enforcing and
monitoring such a contract (e.g. the cost of spending time
and effort in finding an agent, bargaining on the terms of the
contract, and monitoring the actions of the principal/agent).
 The farmer might incur costs in searching for a retailer that
operates in her area (these are commonly referred to as search
costs)
 If actions (or characteristics) between the farmer and retailer are
then revealed to each other via this contract (e.g. retailer will know
practices of farmers, and farmer knows practices of retailer), there
will be reductions in transaction costs
 Despite this reduction, there may be residual moral hazard and
adverse selection (e.g. the farmer doesn’t know about retailer’s
business plans and financial certainty)

22. TRANSACTION COSTS: RONALD COASE (1937)
 Ronald Coase (1937)* posed two Nobel-prize puzzles :
• Why do any firms emerge in a market economy?
• Why not just One Big Firm for whole economy?
• The Coase theorem states that where there is a conflict of property rights,
the involved parties can bargain or negotiate terms that are more
beneficial to both parties than the outcome of any assigned property
rights. The theorem also asserts that in order for this to occur, bargaining
must be costless; if there are costs associated with bargaining, such as
those relating to meetings or enforcement, it affects the outcome.
• Coase argued that market mechanism not cost-free, but involves
transaction costs: time & money to search for sellers & buyers, negotiate
exchange terms, write contracts, inspect results, enforce deals
 Firms will emerge if an “economizing” organization can reduce its
production + transaction costs < market prices
 Firm expansion halts when intra-organizational TC > market prices.
[Coase, R.H., 1960. The problem of social cost. Journal of law and economics, 3(1),
pp.1-44.]

23. TRANSACTION COSTS: INTERNAL AND EXTERNAL
COSTS
 The model shows institutions and market as a possible form of organization to
coordinate economic transactions. When the external transaction costs are higher
than the internal transaction costs, the company will grow. If the external transaction
costs are lower than the internal transaction costs the company will be downsized by
outsourcing, for example.

24. THE COSTS OF TRANSACTING
 Transactions are embedded within social, political, legal institutional
environments that affect transaction costs. These “rules of the game”
affect property, production, distribution, and exchange relations among
economic actors
 Transaction costs are costs of making, enforcing agreements
 Transaction cost theory seeks to explain variations in forms of governance
of economic exchanges
SOURCES OF TRANSACTION COSTS (WILLIAMSON, 1985)
 Environmental uncertainty and bounded rationality
 Bounded rationality: refers to the limited ability people have to process
information
 Opportunism - attempt to exploit forces or stakeholders
 Frequency – is transaction one time or recurrent?
 Risk and specific assets
 Specific assets: Investments that create value in one particular exchange
relationship but have no value in any other exchange relationship.
 Investments lacking alternative uses except at loss of productive value; asset
specificities can be human skills, geographical sites, brand names, dedicated
machinery

25. TRANSACTION COST & STRATEGY
Williamson, O.E., 1999. Strategy research: governance and competence
perspectives. Strategic management journal, 20(12), pp.1087-1108.

26. TRANSACTION COSTS AND STRATEGY
Managers deciding which strategy to pursue must take the following
steps:
 Locate the sources of transaction costs that may affect an
exchange relationship and decide how high the transaction
costs are likely to be
 Estimate the transaction cost savings from using different
linkage mechanisms
 Estimate the bureaucratic costs of operating the linkage
mechanism
 Choose the linkage mechanism that gives the most
transaction cost savings at the lowest bureaucratic cost

27. EXAMPLE: MAKE OR BUY?
 Transaction cost theory examines the conditions under which
organizations chose to internalize some functions (hierarchy) or to
purchase them on the market (e.g., relational subcontracting)
 Example: When should a firm or agency train its own employees,
hire external vendor (college or commercial), or create a jointly
staffed program?
 Are employee job skill requirements changing rapidly &
unpredictably?
 How often must newly hired or promoted workers be
(re)trained?
 Is organizations own training staff more knowledgeable than
external trainers about firm-specific and tacit skills needed by
employees?
 Are external vendors competent, reliable & cost efficient?
EXAMPLE: INTERNALIZE OR OUTSOURCE?

28. SOME APPLICATIONS
 TC theory can be applied to explain diverse organizational
phenomena
 Difficulties in establishing micro-credit lending associations
 Unionization drive successes or failures
 Creation of “company towns” for miners, loggers
 Diffusion of conglomerate
 Mergers-acquisitions vs. technology transfers among
alliance partners

29.  Cooperative “represents a hybrid organizational mode
blending market forces with elements of internal organization
designed to minimize transaction costs”
 Farmers form cooperatives with the objective to generate
greater profits:
(1) by obtaining inputs and services at lower costs (including
transaction costs) than they could obtain elsewhere or that
were not available, and
(2) by marketing their products at better prices or in markets
that were previously not accessible
 Group action by smallholders could strengthen their
bargaining power, facilitate finding institutional solutions to
problems of coordination and public service provision,
compensate for missing markets and reduce transaction
costs.
TRANSACTION COSTS AND COOPERATIVES

30.  How Cooperatives reduce transaction costs? (The case of missing
market)
 Assuming that there are N producers, producing ‘n’ unique products.
The producers also consume these ‘n’ unique products.
 Given that there is no marketplace, bilateral exchange is necessary.
During a given time period, each visits the other in order to
exchange goods.
 Supposing that the cost of each leg of a trip is T rupees. If there are
five individuals and five consumption goods in this economy, then
individual 1 makes four trips, one to each of the other four
producers. Individual 2 makes three trips, and so on. Altogether,
there are [N (N — 1)]/2 = 10 trips, at a total cost of 10T rupees.
 An establishment of a cooperative can solve this problem by
creating a central marketplace which reduces the total number of
trips to five with a total cost of 5T rupees.
 Lower the transactions costs higher will be the operational
efficiency of the market
TRANSACTION COSTS AND COOPERATIVES

31.  Differential transactions costs among households stem from
asymmetries in access to assets, information, services and
remunerative markets handling these access problems requires
institutional innovation
 Poor infrastructure, low population density, and low effective demand
make institutions necessary for risk-sharing and economies of scale in
provision of agricultural services, especially in remote areas.
 Formation of cooperatives reduces the transaction costs as social
networks reduces the fixed costs of participation because members
may be able to access information about price asymmetries and
markets etc within the network.

32. SUMMARIZING TRANSACTION COST
 Transaction Costs are the costs of organizing and transacting
exchanges. This includes search and information Costs, bargaining
and decision costs, and policing and enforcement costs.
 Every exchange involves this cost to different extent influenced
by social institutions (norms of behavior), legal institutions,
political institutions and economic institutions.
 Contracts are necessary to protect from opportunistic behavior &
reduce Transaction Costs.
 Completeness of contracts is also necessary. Incomplete contracts
due to bounded rationality leads to opportunism and escalated
transaction costs.
 Optimal completeness of a contact depends upon the tradeoff
between marginal benefits and marginal costs
 Transaction Cost Economics helps to identify important dimensions
of a transaction and design efficient institutions.
 The most efficient institutional arrangement for conducting
transactions is the one where transaction costs are minimum.