New Institutional Economics

The main theories that form the bedrock of NIE

• Transaction Costs Theory

• Property Rights Theory.

• Agency Theory,
Transaction cost theory
Transaction costs are the costs of negotiating contracts, monitoring
performance and getting to know trading partners (Parada,2002)
• It is the cost of running the economic system (Arrow,1969).
Sources of transaction costs
• Searching for information
• Analyzing options.
• Selecting a product.
• Drawing up the contract.
• Costs resulting from bounded knowledge.
• Coasean framework (Book : The nature of the Firm – Ronald Coase)
Two kinds of relationships for firms
Between Companies - market mechanism- profit maximising
Within firms - entrepreneurial coordination (planning, adapting and
supervising) – efficiency- cost minimising.
Williamson defines a transaction as a process in which goods or a
service are transferred through a technologically separate interface.
Not only a market exchange, but all exchange procedures within the
organization.
A transaction’s dimensions – assets specification, frequency and
uncertainty
Property Rights Theory
• Property rights entitle the owner of an asset to a number of
“privileges”, including the rights of use, benefit and exclusion of
others from them. (Segal & Whinston, 2010)
• Property rights are defined as a bundle of decision rights involving the
asset (also called entitlements in legal terms)
Rights to certain actions-
Rights of access
Rights of exclusion
Rights of profit or cash flow
• Four characteristics of property rights
UNIVERSALITY: property rights can be held by individuals, state,groups; the
entitlements should be completely specified and enforced.

EXCLUSIVITY: all benefits and costs are for the owner; this characteristic is
concerned with durability, which is a duration of these rights (a length of the
entitlement)

TRANSFERABILITY: all property rights can be transferred from one owner to

another in a voluntary exchange; transferability is connected with divisibility,
SECURITY: property rights should be secured from a seizure.

There exists a close relation between property rights and externalities

An important property rights function is achieving greater

internalization of externalities by guiding the incentives

Agency Theory
Agency Theory is very helpful in understanding the relation between
employers and employees, owners and managers or buyers and
suppliers (Eisenhardt, 1989).

An important premise of the theory is the agency relationship that

involves two parties: the principal and the agent.

Principal delegates work to the agent whose role is to perform it

The agent receives gratification for their performance as long as it is
consistent with the principal’s interest.

There is opportunism in the agency relationship, that is both parties of

this relationship have different aims and risk preferences
(Gorynia,1999)

The relationship has inherently two problems –

Agency problem and Risk sharing

Agency Problem
It occurs when there is a conflict between the agent’s goals and the
principal’s desires.
Principal’s problem is to check if the agent acts in the principal’s best
interest. (solution : incentives)

Risk sharing problem

When both parties perceive taking risks differently, and act differently
depending on their risk preferences. (solution: linking their

gratification with the company’s profit)

• Costs associated with Agency Problem
Principal’s costs - Monitoring the agents acting

Agent’s costs - Agent’s expenditures made to gain the principal’s trust

(bonding costs)

Alternative costs – Residual costs which result in the reduction in welfare

experienced by the principal as a result of the divergence from the agent’s
interest.
Built in issues of Agency problem

Moral hazard –
• Lack of effort on the part of the agent

• Agent is shirking his work.

• Not following the terms of contract

• Acts in their own interest.

Adverse Selection
• The misrepresentation of the agent’s abilities.
• Principal’s inability to verify the agent’s claims (skill set. etc)
• Faulty hiring procedures.

Information asymmetry
• Agent knows more than the principal about their own behaviour
• Principal must bear the cost of monitoring and controlling to align agents
interest with theirs.