Managerial Economics A29108: Transaction Costs and Moral Hazard

This essay explores key concepts in managerial economics, focusing on how firms minimize transaction costs and the implications of the principal-agent problem. The discussion begins with an overview of transaction cost theory, referencing Ronald Coase's perspective on why firms exist to reduce market-related expenses. It then delves into various firm structures (sole proprietorship, partnership, and corporation) and how they impact transaction costs, including examples of vertical integration and long-term contracts. The essay also examines criticisms of Coase's theory and presents diverse viewpoints on the purpose of firms. Furthermore, it analyzes the principal-agent relationship and its connection to moral hazard, providing examples such as owner-manager relationships, insurance, and bank-borrower scenarios, along with potential solutions. This assignment highlights the challenges of asymmetric information and suggests strategies to mitigate the problems associated with moral hazard and principal-agent conflicts. This assignment is available on Desklib, a platform providing past papers and solved assignments.

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Managerial Economics A29108
Name:
Institution:

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Discussion of the view that firms exist to minimize transaction costs
A firm is a business organization. It can be a corporation or a partnership, and it has different
levels of legal protection. However, regardless of its legal definition, a firm plays an important
role in markets (What is a firm in economics?, 2016). Transaction cost theory is a theory that
accounts for the actual cost of outsourcing production of products or services. This includes
transaction costs, contracting costs, coordination costs and search costs (what is transaction cost
theory? Definition and meaning, 2016). According to Ronald Coase, firms exist because going to
the market all the time can impose heavy transaction costs. This is because of some time-
consuming factors like hiring workers, negotiating prices and enforcing contracts (Economist,
2010). In his book, "Nature of the Firm" (1937), Coase explained his perspective about why the
firms exist. He also explained under what conditions firms are expected to emerge. For a firm to
emerge, an entrepreneur must come from somewhere and start hiring people. He says it makes
sense for an entrepreneur to hire people to help him do a certain job instead of giving a contract
for the task to be performed.
To understand how the firms minimize transaction costs or to understand why firms exist, it is
important to look at the theory of the firm. To put things clear, the aim of the theory of the firm
is to answer some questions such as why firms exist, why they are structured in a certain way
among other questions. When it is more efficient to produce in a nonmarket environment, the
firms exist as an alternative system to the market-price mechanism. This report's main focus is on
why firms exist. They simply exist to minimize costs which result to profit maximization. Firms
can be categorized regarding sole proprietorship, partnership, and corporation. A sole
proprietorship firm is where an individual owns the firm and directly operates it and has

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unlimited liability. A partnership is when two or more individuals come together to make a firm
while corporations are where a firm is run by appointed managers and are owned by a group of
investors. While transaction cost is any cost involved while making an economic transaction,
firms work very hard to make it easy for customers to get services at the minimum possible
price. For instance, if an individual is planning to import a vehicle from a foreign country
situated several thousand miles away. There are very many transaction costs that the individual
would incur before the vehicle reaches this individual. In the absence of firms, the individual
would have to buy air tickets, book accommodation in the foreign country, have a varied
passport to go to the country among others with all need money. It would also consume a lot of
time for the individual before he/she gets the vehicle. All this work is eliminated by companies
which sell imported vehicles. All the client would need is an internet connection and a computer
or a mobile phone to access the firm's website and purchase online. This will have reduced the
transaction cost by a big margin and it will also save a lot of time for the client. In this example,
the firm will have reduced the transaction cost regarding reducing the number of transactions as
well as reducing the overall cost per transaction.
Firms can also form partnerships with other companies in a bid to reduce the transaction cost.
This move is popularly known as vertical integration. This idea emerged in the 19th century
when Andrew Carnegie described the nature of his company, U.S. Steel. Carnegie had purchased
almost every firm that his company relied on in the supply and distribution chain. This ensured
consistent delivery of materials and distribution as well as reducing the transaction costs.
Instead of choosing the vertical integration way, firms can also choose to have long term
contracts. When tow firms have long-term contracts, it means that the costs will also be
moderated reducing the transaction costs. This would also eliminate any problem that may be

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associated with vertical integration. However, vertical integration sometimes can be the only
certain method of ensuring consistent and low transaction costs. For example, if we think of fast
moving industries such as technology, vertical integration is the better way to prevent
exploitation of one party. Although vertical integration is seen as a way of reducing transaction
cost, it is very important for a company to weigh the reduction of cost against financial
implications that will be caused by the integration. For example, the cost of managing the
company will rise when more branches are added.
It is the goal of every company to be able to sell it products and services to the customers at the
minimum possible price and make lots of profit. For this reason, Toyota has tried some ways in a
bid to reduce the average cost of producing a vehicle. For example, it has long-term contracts
with a body building company called Fisher. Toyota does not buy bodies from Fisher because it's
unable to produce its own bodies but it does this to reduce the cost of production. It also
practices lean supply chain with the firm to ensure that it receives just what and how much is
needed, and where it's needed. This reduces Toyota's inventories and thus its partnership with
Fisher, in the long run, reduces the cost of the transactions.
Over the years, some people have come up with other ideas as to why firms exist. A director and
co-chairman of Deloitte's Center for the edge say that Ronald Coase's theory as to why firms
exist is becoming obsolete (Denning, 2013). However, some people still stick to the Ronald
Coase's theory. A good example is Andrew Hill that defends the theory in the Financial Times.
The big question of who is wrong arises between those defending the Coase's theorem of why
businesses exist and those opposing it. According to Denning (2013), some Coase's assumptions
were wrong even in 1937. Coase claimed that "production could be carried on without any
organization at all." This is not true because some companies offering complex services such as

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airliners could not be carried on without any organization (Denning, 2013). For such services to
exist there must be collaboration which can only be found in a firm/company. In his comment to
Andrew Hill's article, Richard Straub said that there are also strong non-economic reasons as to
why organizations exist. He said they also exist because of political power (Denning, 2013).
Denning also goes ahead sand says that though Andrew Hill is wrong about the validity of
Coase's theory, he is right about his conclusion that trends in technology and globalization may
not necessarily tear down vertically integrated companies. Denning also says that John Hagel is
right that slow-moving bureaucracies are doomed. The different opinions from different people
raise the question of how true is the Ronald Coase's theorem. Do firms exist to minimize the
transaction costs? With these, it is, therefore, my opinion that more people should continue doing
research to determine why exactly firms do exist.
How principal-agent relation is linked to the issue of moral hazard
A principal-agent relationship is an arrangement where one individual legally appoints another
individual to act on his/her behalf. The agent, in this case, should not have any conflict of interest
while performing the task assigned. The law is called an agency, and its guidelines are
established by the law of agency. However, in the course, some problems come up that cause
what is known as the principal-agent problem. It develops when a principal creates a hostile
environment which de-motivates the agent. On the other hand, moral hazard is when one party
gets involved in a risky event with the knowledge that it is protected against the risk and the
other usually the principal will incur the cost. A good example of a moral hazard is when an
individual is driving a vehicle carelessly because he knows if he causes an accident; it is the
insurance company that will incur the cost and not him/her.

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A moral hazard can exist in two cases:
i. Where there is the lack of shared information. For instance, a firm which is on the verge
of collapsing may sell its investments to the public. In this case, the firm owners know
that it will collapse soon but the public investing in it may think that all is good.
ii. The other case is the principal-agent problem. A good example of a moral hazard here is
when a real estate agent recommends a certain house to a client just because he/she wants
to make a sale, but fail to tell the client that of late, there have been a lot of crimes in the
neighborhood. Another example of a moral hazard involving the agent is the case of a
salesperson that is paid with no commission; the person may decide to work with less
effort because he/she knows that at the end of the day payments must be made. In the
human society, a lot of principal-agent relationships exist such as shareholder-manager
and manager-workers just to mention a few.
To examine the severity of moral hazard on the principal-agent relation, it is important to look at
some examples in detail of the moral hazards that exist. One is the owner-manager relationship.
In this case, the manager is hired by the owner to perform a certain project. The profitability of
the project to the owner depends on how the manager performs his/her actions. The manager
may choose to take actions which will favor him rather than favor the owner. Once the manager
has chosen do the project in his favor, it becomes a moral hazard.
Another moral hazard is the one involving insuring companies and insured individuals. In this
case, the insured individuals may take advantage and become careless just because they are not
the one to incur the cost in case something bad happens. We can also have a moral hazard
between the manufacturers and their distributors. This can happen in the case where a distributor

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fails to take good care of the goods he is entitled to distribute. This can lead to damage or loss of
the goods, and instead of caring the burden, he/she might come up with a story in his favor and
the losses end up being incurred by the manufacturer. There is also a likelihood of a moral
hazard between banks and their borrowers. This may happen in the case when a borrower gets a
loan from a bank with a fixed interest rate. In this case, the borrower may choose to increase the
riskiness of the investments because the loan is not growing by a bigger margin. With an
increase of riskiness in investments, an increased likely hood of failure arises (Covitz et al.,
1999). This may have led to the collapse of many banks earlier and to mitigate this problem they
have been imposing more collateral requirements on borrowers (Covitz et al., 1999).
In general, the problem of moral hazard has recently been associated with insurance. Many
people have been insuring their companies, and after that, they no longer take sufficient steps to
reduce the risk of the insured harm from occurring. This reduces the efficiency of many firms
including the insuring companies. However, there are certain steps that can be recommended to
end or reduce the issue of moral hazard or principal-agent problem.
To solve this problem, it is important to note that asymmetric information is a cause of moral
hazard. Sometimes referred to as information failure is a situation where one part of the agency
or economic transaction possesses greater knowledge than the other party. This mostly happens
when a seller of a good has more knowledge than the buyer, though the opposite can also
happen. In this case, the party with the extra information is more likely to behave inappropriately
or take advantage of the other party to benefit more. This particular moral hazard can be
controlled by putting regulations that ensure equal sharing of information between the parties in
relation. There are also other ways of controlling the principal-agent problems which we are
going to look at in this report. They include

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 Monitoring- in the manager-shareholder relation, the shareholders should come up with a
way of monitoring the performance of their managers. This can be done by hiring experts
to examine the manager's performance and operations and also by implementing some
satisfactory models (Griffiths and wall, 2007).
 Introducing flexible working hours- this is mostly between workers and managers. In the
modern world, the lifestyle has greatly changed, and more people expect to spend more
time with their families, they expect to go on holidays among other things. If a flexible
schedule for the workers is not in place, they might lose concentration at work. This
situation can lead to a poor output of the business. Flexible working hours can reduce the
likely hood of a moral hazard. A moral hazard, in this case, occurs when a worker is at
work and doing the minimum work possible just because he/she is not happy with the
time he/she is at work.
 Uses of incentives-examples of incentives that can be instituted include performance
bonus, profit sharing, and basic salary increment. This can make managers behave in a
way that is consistent with shareholders interests. However, the incentives should not
only be instituted to the managers alone, but the workers should also be included. This
motivates the workers, and the long run results are increased profitability.
 Division of labor and assignment of authority- In most situations, workers tend to reduce
the amount of work if they are not closely monitored. This raises the issue of a need to
hire more managers to closely supervise the workers.
 Part ownership- if the workers can be given part of the company in term of shares, they
would start seeing themselves as owners instead of seeing themselves as workers. This
way the workers will have an opportunity to participate in decision-making, and it can

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solve some principal-agent problems between the managers & workers and owners &
managers.
 Offering long term contract- this mostly applies to the manager. If a manager is offered a
long term contract encourages the manager to develop strategies that will benefit the
company regarding say profit maximization.
Performance rewards- here the manager can give rewards to the best performing workers on
behalf of the shareholders. The rewards can be in the form of monetary and promotion and this
can increase the morale of the workers and reduce some principal-agent problems.
For these principal-agent problems to be solved in organizations, the shareholders as well as the
managers need to be fully informed and work towards achieving same objectives. Motivation is
also important for all parties involved as it encourages the workers to work more and keeps them
out of the moral hazard.

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