What is Rational Choice Theory?

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Definition:

Rational choice theory is a presupposition in economic thought that individuals faced with a decision will select the option that is in their rational self-interest.

🤔 Understanding rational choice theory

Classical economics rests on the assumption that individuals are rationally self-interested. This assumption, called rational choice theory (sometimes called rational action theory), is foundational to many economic models of consumer behavior. The premise of rational choice theory is that people don’t randomly pick items off the shelf. Instead, there is a logical decision-making process that weighs the costs and benefits of options against one another. A rational person will always select whichever option provides the greatest net benefit to them. However, net benefit is not just money. It can include things like love, respect, admiration, power, belonging, and even the personal satisfaction derived from improving the lives of others.

Example

Imagine a consumer choosing between two cars. Car A is cheaper than Car B, so he chooses Car A. This buyer only cares about price. His behavior is compatible with rational choice theory.

Pretend another consumer is choosing between the same two cars — but this person only cares about the color of the car. He likes that Car B is red, so he chooses Car B (despite the higher price). This behavior is also compatible with rational choice theory. The second consumer has different preferences, but he pursues them rationally.

Takeaway

Rational choice theory is like gravity…

Gravity is a natural law that underpins physics. When you let go of an object, you can reliably predict that it will fall to the ground. You can even calculate how long it will take to hit the ground with mathematical precision. Likewise, rational choice theory underpins classical economics. When a rational person faces a choice, you can reliably predict that they will choose the option that is better for them. It’s just more difficult to calculate all of the hidden preferences and considerations that might enter the equation.

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What is rational choice theory?

Rational choice theory attempts to explain how individuals make decisions using a structured and logically consistent process. The theory suggests that when a person is given a choice between alternatives, they will judge the costs and benefits of each option. Then, after comparing each option's implications, they will rank-order the possibilities and choose the one that provides the most significant personal gain.

According to the theory, choices are not arbitrary or random. Instead, they are deliberate and logical. Therefore, observed decisions should be consistent (if A is better than B, they will always choose A) and adhere to transitivity (if A is better than B, and B is better than C, then by the transitive property, A is better than C), which implies they are predictable.

What is a real-world example of rational choice theory in action?

Imagine driving home after a long day at work. You are trying to decide what to do for dinner. This is an economic decision. One option is to cook the chicken you have in the refrigerator; the other option is to order a pizza. To decide between these options, you probably weigh the pros and cons of each. Cooking dinner is cheaper but requires more effort. Then, you have to deal with the dishes afterward. Ordering a pizza costs a little more, but it requires minimal effort and no clean-up.

There is an internal process going on in your head that considers the consequences of spending that extra money — how stressful your day has already been and whether or not you like the taste of delivered pizza. If you could assign numbers to all of those considerations, you could add up the value of each option.

But, even without putting the figures on paper, some internal process is crunching the numbers. You will figure out what is best for you, given your current situation. And if you could reset the conditions of that same decision again, you would reach the same outcome.

What is the purpose of rational choice theory?

The purpose of rational choice theory is to provide structure to understanding human action. By laying out a set of rules that people appear to follow, scientists can understand and model how they behave. From such an economic model, they can predict how people might act in different circumstances and how those actions would change under various conditions.

Rational choice theory creates the underlying set of assumptions that allow social scientists to make sense of observed human behavior.

How does self-interest play into rational choice theory?

At the core of rational choice theory is the idea that people are rationally self-interested. That just means that when people make a choice, they do so with their best interest in mind. Since the benefits of a personal decision are not always about money, economists invented a different metric to quantify the way people assess the value of an alternative. It’s called utility.

Utility is a measure of how you feel. If one thing makes you happy, you might say it gives you 100 utility points (called utils). If something else makes you even more satisfied, it must provide you with something more than 100 utils. Other things might even provide negative utility. If you would rather not mow the lawn, doing so might provide -20 utils.

Economic theory suggests that a rational person will seek utility maximization. However, utility is an internal measurement. People prefer the individual choices that maximize their own utility, not those that maximize the total utility of everyone in the world. That is what self-interest means.

But many things provide utility to an individual, including making someone else happy. That is why self-interest should not be confused with selfishness. Under rational choice theory, even someone like Mother Teresa, who sacrificed to help others, was still acting rationally and with self-interest. It’s just that she derived more internal satisfaction by helping others than she would have by doing other things with her life.

What is the difference between rational choice theory and invisible hand theory?

Adam Smith wrote about an invisible hand that guides the markets. What he observed was that an economy does not need a controlling entity to coordinate buyers and sellers. While a command economy would instruct farmers what to plant and workers what to build, it wasn’t necessary. Allowing individuals the freedom to plant whatever crops they want, and workers to buy whatever gives them pleasure, does not lead to chaos.

Instead, these free-market economies, using a laissez-faire approach to market transactions, could coordinate the allocation of resources better than a central authority — even if that authority had the best of intentions. An efficient structure emerges without a central planner because every person makes decisions based on rational self-interest. Therefore, a rational choice approach explains why the invisible hand theory works.

It happens because every rational agent approaches every decision from the perspective of utility maximization. If a trade occurs, it is because both people involved in the exchange are made better off by it. If either person would be injured more than improved, they could simply decline the deal. Therefore, every voluntary trade that happens must improve the allocation of resources. And continual improvement in the allocation of resources can only lead toward a more optimal outcome.

If a farmer makes a poor decision about what to plant, consumers don’t buy the product. If an entrepreneur offers something that nobody wants, a central planner doesn’t have to tell him to stop. The buyers do that on their own, and the entrepreneur goes out of business. If there is not enough of something, buyers offer a higher price to encourage more of that thing to be brought to the market. This symphony of rational decision making signals the rest of the marketplace how to respond, as though an invisible hand were guiding their actions.

What are the strengths and weaknesses of the rational choice theory?

The assumptions of rational choice theory are easy to understand and tend to ring true to most people. After all, we aren’t out here flip-flopping on whether chocolate or vanilla ice cream makes for a better cone. Our individual preferences are consistent, and our decisions are based on what feel like logical internal processes. That’s just common sense. But things get a little more complicated when you pull on that thread.

For instance, why would you need to hide the Girl Scout cookies from yourself? A rational person that doesn’t want to eat them would simply not buy them or restrain themselves from opening the box too often. Does the fact that you do eat them reveal that doing so provides more happiness than not eating them (even accounting for gaining more weight than you might like)? If not, eating them is illogical. If so, hiding them would be an irrational decision.

Behavioral economists and psychologists have been poking holes in ideas presented by rational choice theorists for decades now. It is becoming increasingly clear that while rational choice theory is a starting point for modeling economic behavior, there is more to the story that we don’t fully understand.

Also, as strong as rational choice theory looks in general practice, it does have one significant weakness — It cannot really be validated. Consider the argument carefully. Every person weighs options based on subjective preferences and internal conditions. No outside person can view the internal calculations. Instead, the results of those calculations reveal the outcome of that process. In other words, rational choice theory assumes every decision must be rational because people are rational.

Clearly, that conclusion requires some circular logic. If a person drinks a glass of oil, are we to assume that it reveals the fact that this person prefers the taste of oil? Perhaps this person made a mistake, or maybe human decisions are not always rational. We cannot argue that a choice is rational by pointing to the decision itself as evidence of rationality.

How does rational choice theory explain bad decisions?

According to rational choice theory, any decision that is made cannot be inferior to the ones that were passed over. A sensible person would always choose the option that provides them with the best outcome, given perfect information. Therefore, if a decision appears to have been the wrong choice to us as observers, we just don’t understand what factors went into the decision.

Perhaps information was hidden from the decision-maker. For example, imagine that you watch someone purchase an apple, take a bite, and then throw it away. It would appear that this person made a poor decision to buy that apple. But perhaps they didn’t know there was a worm inside at the time the decision was made. If that information were known, they probably would have picked up a different apple.

In other situations, the information might not be available at all when the decision occurs. If you purchase tickets to an outdoor concert and then decide not to go because of the weather, that wasn’t necessarily a poor decision. If you knew what the outcome would be, you would have weighed your options differently.

But we all make decisions every day without knowing what the future will hold. We have to assess the likelihood and impact of each possible outcome and do the best we can. Just because we occasionally end up with an adverse outcome does not necessarily mean the decision itself was irrational at the time it was made.

How is rational choice theory applied in other fields?

Rational choice theory is not limited to the field of economics. Most sciences dealing with the behavior of individuals assume to varying degrees that people behave in their own rational self interest. Psychologists use the idea of rational choice to provide structure for people facing difficult decisions. In political science, as well, voter actions and the actions of public officials can be understood through the lens of rational choice theory.

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