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:


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).


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:


When an individual prefers A over B and does not view them as equally preferred.


When an individual strictly prefers A over B or is indifferent between the two.


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.


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

Several criticisms of rational choice theory exist, with most related to a belief that few people are consistently rational in their choices.

Since people are not always rational, 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.

What are the main elements of the Rational Choice Theory?

The main elements of the Rational Choice Theory are:

Connected Economic Concepts

Market Economy

The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.

Positive and Normative Economics

Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.


When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation. 

Asymmetric Information

Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.


Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.

Demand-Side Economics

Demand side economics refers to a belief that economic growth and full employment are driven by the demand for products and services.

Supply-Side Economics

Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.

Creative Destruction

Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.


An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.

Animal Spirits

The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.

Paradox of Thrift

The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.

Circular Flow Model

In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.

Trade Deficit

Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.

Market Types

A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.

Rational Choice Theory

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.

Conflict Theory

Conflict theory argues that due to competition for limited resources, society is in a perpetual state of conflict.

Peer-to-Peer Economy

The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.


The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.

Command Economy

In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Labor Unions

How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.

Bottom of The Pyramid

The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”


Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.

Market Fragmentation

Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.

L-Shaped Recovery

The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth.  The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.

Comparative Advantage

Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846.  Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.

Easterlin Paradox

The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.

Economies of Scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Economies of Scope

An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.

Price Sensitivity

Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Negative Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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