Differences and Similiarities Between Agency Theory and Transaction Cost Theory

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‘An agency relationship exists when one or more individuals (called principals) hire others (called agents) in order to delegate responsibilities to them’ (Baiman (1990: 342)) Agency relationships are administrated by implicit or explicit contracts between agents and principals. The assumption of agents’ self – interest which contradicts with the principals’ interest is the basis of the agency problem. According to Alawattage and Wickramasinghe, agency theory suggests two fundamental reasons for the agency problem. First is the goal contradiction between the agent and principal. Second reason is the information asymmetry between the agent and principal.  Principal does not know the amount of effort the agent is putting in his work. This information it can only be accessed with incurring the additional cost (agency cost).  The challenge for the principal is to devise the contract which motivates the agent to a level of effort that would maximise the principals’ profit. Transaction cost economics ‘takes transaction as the focal unit of analysis’ (Alawattage, Wickramasinghe). TCE focus is on comparative understanding of the alternative arrangements within which transactions take place. It tries to explain why the firms exist and ‘why are some transactions more likely to be executed within one form of institutional arrangements, whereas others tend to be associated with different ones?’ (Alawattage, Wickramasinghe). TCE recognizes three institutional arrangements: market, hierarchy and hybrid.  

Differences between Agency Theory and TCE|
Agency theory| TCE|
The agency problem arises when agents’ interests and behaviour are not consistent with principles’  interests.| The agency problem arises when interests and behaviours of parties to a transaction are not consistent with each other.| Principals and agents are rational.| Holds the assumption of ‘bounded rationality’.| Perfect contracts are possible. Thus its analytical focus is on modelling the...
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