How Does Self Interested Behavior Affect Opportunity Cost and Agency Theory?
Principle of Self-Interest
When most people think of finance, ideas such as stock exchanges, banks, and corporations often come to mind. Yet as a social science, business is linked to the decisions and behaviors of its players. The Principle of Self-Interest suggests that all things being equal, people act in their own financial self-interest.
For some, the Principle of Self-Interest may seem cold and unfeeling because there are other aspects to life other than attaining money. The principle does not presuppose that money is the most important aspect in anyone’s life. Financial transactions often take place without parties meeting face-to-face. Buying and selling stocks, for example, are transacted by a telephone call to a broker or a click of a mouse online. Often, the two parties are unaware of the people with whom they are doing business. Therefore, they buy and sell securities based on what is good for them even if it means a loss of value for the other party. Generally, the Principle of Self-Interested Behavior explains human behavior well and captures much of its variability in competitive financial markets.
Opportunity Cost
The Principle of Self-Interest comes to light when it is understood that people often choose among more than one alternative or opportunity. A person can not attend a party and study for an exam at the same time. A person can not often choose to work full time for two different companies simultaneously. Decision-making is a weighing of the pros and cons of not only choosing one alternative but of not choosing another. Choosing to work for one company may afford an attractive retirement plan but another may offer an excellent health plan. The fact that not everyone’s situation is the same describes why some people will work for one company and other people choose another company. The difference between two or more options is known as the opportunity cost.
Agency Theory
Another aspect of The Principle of Self-Interest is what is known as agency theory. Agency theory is concerned with the conflicts of interest that can arise in a principal-agent relationship. S A Principal-agent relationship occurs whenever one person (agent) acts in the interest of another person (principal) such as when managers of a firm work to maximize shareholder equity. A manager working in his/her own self interest has an incentive to do what is right for him/her regardless of how it affects the firm’s owners. As such, the Principle of Self-Interest describes why a corporation’s owners make rules as to what power a manager is given or why they institute a profit-sharing program so that the self-interest of the manager is more in line with the self-interest of the owners.
The Principle of Self-Interest does not suggest that people are cold and wish to attain money as the focal point of their lives. Instead, it indicates that given the opportunity, people will act in their own financial self-interest to avoid losses and realize gains by making good decisions. In conjunction with the other Principles of Competitive Financial Markets, it helps create an accurate picture of the financial transaction landscape.
This post is part of the series: The Competitive Financial Environment
The competitive financial environment is governed by four distinct principles. These principles encompass the idea that attaining value is a matter of competition resulting in winners and losers. The principles outlined here are an overview of this competitive environment.
