Syllabus A. Role Of The Senior Financial Adviser A3. Ethical and governance issues

A3e. Transaction Cost Theory 4 / 7

Syllabus A3e)

Explore the areas within the ethical framework of the organisation which may be undermined by agency effects and/or stakeholder conflicts and establish strategies for dealing with them

Transaction cost theory


Transaction costs occur when dealing with another party.

If items are made within the company itself, therefore, there are no transaction costs

  • Analysing these costs can be difficult because of:

    • Bounded rationality - our limited capacity to understand business situations

    • Opportunism - actions taken in an individual’s best interests

  • Company will try to keep as many transaction as possible in-house in order to:

    • reduce uncertainties about dealing with suppliers

    • avoid high purchase prices

    • manage quality

Are the transaction costs (of dealing with others and not doing the thing yourself) worth it?

The 3 factors to take into account as to whether the transaction costs are worthwhile are:

  1. Uncertainty

    Do we trust the other party enough?

    • The more certain we are, the lower the transaction / agency cost

  2. Frequency

    how often will this be needed

    • The less often, the lower the transaction/agency cost

  3. Asset specificity

    How unique is the item

    • The more unique the item, the more worthwhile the transaction / agency cost is

Applied to Agency theory

This can be applied to directors who may take decisions in their own interests also:

  1. Uncertainty - Will they get away with it?

  2. Frequency - how often will they try it?

  3. Asset specificity - How much is to gain?