rational-choice-theory

What Is Rational Choice Theory? Rational Choice Theory In A Nutshell

Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.

Understanding rational choice theory

Rational choice theory is used to model decision-making – particularly in the field of microeconomics – where it helps economists better understand the collective behavior of individuals and how their actions impact society as a whole.

The theory makes two assumptions that describe rational choice:

  • Completeness – this means the individual can say which option they prefer among a set of alternatives. They may prefer A over B, B over A, or both (indifference).
  • Transitivity – this refers to the property of preference relationships where if A is preferred over B, and B is preferred to C, then A must be preferable to C. The relationship between A and C will be determined by the strongest preference relationship in a set of alternatives.

The preferences themselves can also be:

  • Strict – when an individual prefers A over B and does not view them as equally preferred.
  • Weak – when an individual strictly prefers A over B or is indifferent between the two.
  • Indifferent – when the individual prefers neither A nor B.

From these preferences for choice alternatives, various individuals, businesses, and governments can develop utility functions that best reflect those preferences.

Rational choice theory and utility function

The preference of an individual is often described by its utility function, which defines their preferences for goods and services beyond their explicit monetary value. Utility function is a measure of how much someone desires something and, as a result, varies from person to person. By extension, utility functions can reflect one’s attitude to risk acceptance, risk neutrality, or risk aversion.

The idea that rational choices were made to maximize utility function arose in the 19th century. Utilitarian philosophers were seeking to develop an index that could measure how beneficial different governmental policies were for different people. Around the same time, proponents of Adam Smith also endeavored to refine the economist’s ideas about how an economic system based on individual self-interest would work. 

Some realized the two approaches could be combined. Indeed, utility-maximization has several characteristics that help account for its continued dominance in economics. Indeed, the approach has several important benefits for governments and policymakers:

The development of welfare criteria

Rational choice theory incorporates the principle that people’s own choices should determine government welfare criteria. These criteria are effective because they are aligned with modern democratic values.

Compact theory

Predictions of individual behavior can be made with a simple description of the individual’s objectives and constraints. The approach is considered more streamlined than psychological theories which posit that choices depend on a much wider array of factors.

Wide scope

Utility maximization also has a spectacularly wide scope. It has been used by governments to analyze choices in consumption, savings, education, child-bearing, migration, and crime. In business, it also has been used to evaluate decisions concerning output, recruitment, and investing.

Rational choice theory assumptions

Rational choice theory makes the following assumptions:

  • Every action is rational and is made by considering rewards and costs.
  • For an action to be completed, the reward must outweigh the cost.
  • When the value of a reward is less than the value of the costs incurred, the individual will cease performing the action.
  • Individuals use the resources at their disposal to optimize rewards.

As a result, the theory argues that an individual is in control of their decisions because they use rational considerations to evaluate the potential benefits and consequences. They do not make choices that are based on unconscious drivers, traditions, or external influences.

The three concepts of rational choice theory

Rational choice theory is based on three concepts:

Rational actors

Or the individuals in an economy who make rational choices based on the available information. As we noted earlier, rational actors seek to maximize their advantage and minimize their losses wherever possible.

Self-interest – or actions undertaken by the individual that elicit a personal benefit. Adam Smith was one of the first to use self-interest in the context of economic theory.

The invisible hand – a metaphor and theory for the hidden forces that shape a free market economy. The theory argues that the best interests of society are fulfilled when individuals act in their own self-interest via freedom of production and consumption.

Criticisms of rational choice theory

There do exist several criticisms of rational choice theory, with most related to a belief that few people are consistently rational in the choices they make. Since people are not rational all of the time, assuming rationality to be the case may lead to incorrect conclusions.

For one, rational choice theory does not account for non-self-serving behavior such as philanthropy or any other situation where there is a cost but no reward to the individual. What’s more, the theory does not account for ethics or values and the impact of these on decision-making.

Many others suggest that rational choice theory ignores social norms. In other words, most people follow standard or accepted ways of behaving irrespective of whether they will personally benefit from doing so. Similarly, some individuals will behave in habitual ways and stick to established routines even in the face of higher costs and lower benefits.

Though somewhat outdated, Smith’s assumption that individuals acting in their own self-interest benefits society is also flawed. Fishermen who catch as many fish as possible are responsible for the collapse of wild fish populations. Cattle farmers clearing rainforest for pasture causes habitat loss and soil degradation. In these cases, self-interest is irrational and does not benefit society. In fact, these choices are delusional, myopic, ignorant, and destructive.

Key takeaways:

  • Rational choice theory is a set of guidelines that explain economic and social behavior. The theory is used to model decision-making in microeconomics to help economists understand the behavior of individuals and their impact on society as a whole.
  • Rational choice theory enables individual preferences to be represented as utility functions. These functions define consumer preferences for goods and services that extend beyond the monetary value of those goods and services. The maximization of utility is used in economic management and the development of policy.
  • Since rational choice theory assumes human decision-making to be rational, critics suggest it does not account for situations where it is irrational. This may occur in instances where an individual displays non-self-serving behavior such as philanthropy. It may also occur when the individual makes decisions based on habitual ways of operating or societal conformity.

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