welcome to another video on organizational or corporate governance theories in this video we will explain the transaction cost economics Theory and its perspective on corporate governance we will explore how this economic theory sheds light on the intricate world of corporate governance and the decisions organizations make to optimize efficiency and reduce transaction costs so let's Dive In first let's understand the core concept of transaction cost economics or transaction cost theory transaction cost economics is a theory that originated in the field of economics it seeks to understand the costs involved in conducting transactions between different parties within an organization or a market put simply according to Coast 1937 transaction cost theory examines whether firms should make something in-house or to Source it outside from another company if a firm decide to Source from within the organization or especially from outside the organization these leads to transactions and all of such transactions attracts costs considering this transaction cost economics explores the costs involved in conducting transactions between various parties within and outside an organization these transactions costs can include agreements contracts and interactions between shareholders management suppliers and customers Studies have summarized these costs into four main costs which are the cost of searching for information haggling costs monitoring and enforcement costs and decision-making costs these transaction costs can be significant in coordinating activities and aligning interests among various organizational stakeholders before we go any further let us explain these different types of costs so first the cost of searching for information this refers to the expenses incurred in gathering relevant information and searching for suitable business partners or potential suppliers of goods than services in any transaction or business activity parties need to collect information about market conditions available suppliers prices and product quality these costs arise from research data collection and the time and effort spent in finding the best options reducing search and information costs can lead to more efficient decision making and improve transaction outcomes haggling costs these costs are associated with the process of reaching agreements and contracts between parties involved in a transaction negotiating terms prices and conditions can be time consuming and may require Legal Assistance or third-party mediation these costs arise from the efforts made by both parties to protect their interests and ensure a mutually beneficial arrangement reducing bargaining negotiation or haggling costs involves effective communication compromise and building trust between the parties monitoring and enforcement costs this are the expenses involved in ensuring that all parties in a transaction fulfill their contractual obligations and act in the best interests of the organization these costs arise from the need to supervise and oversee the performance of agreements contracts or Partnerships the monitoring bit of this contractual agreement may involve regular audits inspections or performance evaluations to detect any deviations from agreed upon terms as for the enforcement costs these may arise when parties need to take action to ensure compliance which may include legal fees or penalties reducing monitoring and enforcement costs requires transparent and well-defined contractual terms and a reliable system for tracking performance finally decision making costs these are the expenses associated with making choices among different Alternatives in a transaction or business context these costs arise from the time effort and resources needed to gather information analyze options and reach a decision it is worth noting that transaction cost economics does not aim to eliminate these costs entirely as some level of transaction costs are inevitable in any economic exchange or firm activity instead the theory focuses on reducing transaction costs to achieve greater efficiency and optimal decision making in organizing economic activities now let's see how transaction cost economics sheds light on corporate governance structures as discussed in our other corporate governance videos there are three primary players in corporate governance which are board of directors shareholders and the management each of them plays a crucial role in decision making and overseeing the organization's operations where shareholders are the owners of the company responsible for electing the board of directors and safeguarding their interests management oversees day-to-day operations making decisions to achieve company objectives the board of directors represents shareholders sets policies and provides oversight to ensure the company's success and adherence to ethical standards transaction costs theory in the context of corporate governance explains how managers shareholders and the board of directors design governance structures to minimize costs associated with aligning interests between managers and shareholders and preventing conflicts it is argued that mechanisms such as performance-based compensation and independent directors reduce transaction costs and enhances corporate performance considering these major corporate players and their relationships transaction cost theorists argue the corporate governance assumptions of information asymmetry opportunism and rationality these assumptions help explain the presence of transaction costs and influence the design of governance structures to minimize costs and enhance firm performance by addressing these assumptions corporate organizations can effectively manage transaction costs and improve their overall efficiency in economic transactions of the organization and the decision-making of the board of directors these assumptions made by transaction cost theorists also describe human behavior from an economist perspective and it will be useful to go through what is meant by each of these assumptions by information asymmetry the theorists of the theory argue that corporate players have different levels of information and knowledge of transactions this can lead to one party having an advantage over the other potentially resulting in information gaps or misalignment of interests this brings us to the second assumption which is opportunism due to the gaps in information and knowledge parties can act in their self-interest and exploit opportunities to maximize their gains even at the expense of others in corporate governance this assumption emphasizes the need for mechanisms to mitigate opportunistic Behavior such as aligning incentives implementing monitoring systems and setting clear contractual terms to reduce the risks of opportunistic actions by managers or shareholders the third assumption which is rationality implies that parties involved in transactions are rational decision makers they seek to minimize transaction costs and maximize their utility or benefits in corporate governance understanding rational behavior is crucial for Designing governance structures that align interests incentivize performance outcomes and promote efficient decision making considering the discussed corporate governance assumptions of transaction costs theorists proponents of the theory have made recommendation on the structure and composition of corporate boards that will spur an efficient decision-making process and that could lead to enhanced firm performance outcomes according to transaction cost theory in corporate governance the recommendations for board composition to enhance firm performance are as follows board Independence board diversity and abolishing CEO duality by board Independence in this context we refer to the presence of directors on the board who are not affiliated with the company's management or major shareholders they are impartial and free from conflicts of interest ensuring objective oversight and decision making these types of directors are also called outside directors or non-executive directors according to transaction cost theory including a higher proportion of independent directors on the board is essential as they bring objectivity and an outside perspective acting as Watchdogs to safeguard shareholders interests and reduce potential conflicts of interest to accomplish this role these directors may also take on the role of the board committees such as audit compensation and nomination committees this Rolls by independent directors can enhance board effectiveness the recommendation of eliminating CEO Duality involves separating the roles of CEO and board chairperson this separation creates a balance of power as the CEO's role involves management responsibilities while the board chairperson oversees board functions and represents shareholders interests this alongside the higher proportion of independent directors mitigates the possibility of managerial opportunism misalignment of interests between shareholders and the management transaction cost theorists also recommends the presence of board diversity a diverse board with directors possessing a wide range of expertise industry Knowledge and Skills is beneficial diverse perspectives contribute to better decision making and risk management as directors can offer insights from various backgrounds and experiences here will be where we stop for this video but we will like to leave you with some work we would like you to do some research and find the main criticisms of the transaction cost theory in corporate governance we have included some useful information in the description below we hope you enjoyed this video on the transaction cost economics and the corporate governance perspective remember understanding transaction costs can lead to better governance decisions and improve organizational performance please remember to like and feel free to 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