Rational Choice Theory

Rational Choice Theory
What Is Rational Choice Theory?

Rational choice theory states that individuals use rational calculations to make
rational choices and achieve outcomes that are aligned with their own personal
objectives. These results are also associated with maximizing an individual's self-
interest. Using rational choice theory is expected to result in outcomes that
provide people with the greatest benefit and satisfaction, given the limited option
they have available.
KEY TAKEAWAYS
 Rational choice theory states that individuals rely on rational calculations to

make rational choices that result in outcomes aligned with their own best
interests.
 Rational choice theory is often associated with the concepts of rational
actors, self-interest, and the invisible hand.
 Many economists believe that the factors associated with rational choice
theory are beneficial to the economy as a whole.
 Adam Smith was one of the first economists to develop the underlying
principles of the rational choice theory.
 There are many economists who dispute the veracity of the rational choice
theory and the invisible hand theory.
Understanding Rational Choice Theory
Many mainstream economic assumptions and theories are based on rational
choice theory. Rational choice theory is associated with the concepts of rational
actors, self-interest, and the invisible hand.
Rational choice theory is based on the assumption of involvement from rational

actors. Rational actors are the individuals in an economy who make rational
choices based on calculations and the information that is available to them.
Rational actors form the basis of rational choice theory. Rational choice theory
assumes that individuals, or rational actors, try to actively maximize their
advantage in any situation and, therefore, consistently try to minimize their
losses.
Economists may use this assumption of rationality as part of broader studies

seeking to understand certain behaviors of society as a whole.
Self-Interest and the Invisible Hand

Adam Smith was one of the first economists to develop the underlying principles
of the rational choice theory. Smith elaborated on his studies of self-interest and
the invisible hand theory in his book “An Inquiry into the Nature and Causes of
the Wealth of Nations,” which was published in 1776.
The invisible hand itself is a metaphor for the unseen forces that influence a free
market economy. First and foremost, the invisible hand theory assumes self-
interest. Both this theory and further developments in the rational choice theory
refute any negative misconceptions associated with self-interest. Instead, these
concepts suggest that rational actors acting with their own self-interest in mind
can actually create benefits for the economy at large.
According to the invisible hand theory, individuals driven by self-interest and

rationality will make decisions that lead to positive benefits for the whole
economy. Through the freedom of production, as well as consumption, the best
interests of society are fulfilled. The constant interplay of individual pressures on
market supply and demand causes the natural movement of prices and the flow
of trade. Economists who believe in the invisible hand theory lobby for less
government intervention and more free-market exchange opportunities.
Advantages and Disadvantages of Rational Choice Theory

There are many economists who dispute the veracity of the rational choice theory
and the invisible hand theory. Dissenters have pointed out that individuals do not
always make rational, utility-maximizing decisions. The field of behavioral
economics is a more recent intervention into the problem of explaining the
economic decision-making processes of individuals and institutions.
Behavioral economics attempts to explain—from a psychological perspective—

why individual actors sometimes make irrational decisions, and why and how
their behavior does not always follow the predictions of economic models. Critics
of rational choice theory say that, of course, in an ideal world people would
always make optimal decisions that provide them with the greatest benefit and
satisfaction. However, we don't live in a perfect world; in reality, people are often
moved by emotions and external factors.
The Nobel laureate Herbert Simon, who rejected the assumption of perfect

rationality in mainstream economics, proposed the theory of bounded rationality
instead. This theory says that people are not always able to obtain all the
information they would need to make the best possible decision. Simon argued
that knowledge of all alternatives, or all consequences that follow from each
alternative, is realistically impossible for most decisions that humans make.
Similarly, the economist Richard Thaler pointed out further limitations of the
assumption that humans operate as rational actors. Thaler's idea of mental
accounting shows how people place greater value on some dollars than others,
even though all dollars have the same value. They might drive to another store to
save $10 on a $20 purchase but they would not drive to another store to save
$10 on a $1,000 purchase.
Like all theories, one of the benefits of rational choice theory is that can be
helpful in explaining individual and collective behaviors. All theories attempt to
give meaning to the things we observe in the world. Rational choice theory can
explain why people, groups, and society as a whole make certain choices, based
on specific costs and rewards.
Rational choice theory also helps to explain behavior that seems irrational.
Because a central premise of rational choice theory is that all behavior is rational,
any action can be scrutinized for its underlying rational motivations.
Pros of Rational Choice Theory

 Helpful in explaining individual and collective behaviors
 All theories attempt to give meaning to the things we observe in the world.
 Can help to explain behavior that seems irrational
Cons of Rational Choice Theory

 Individuals do not always make rational decisions.
 In reality, people are often moved by external factors that are not rational,
such as emotions.
 Individuals do not have perfect access to the information they would need
to make the most rational decision every time.
 People value some dollars more than others.
Examples of Rational Choice Theory

According to rational choice theory, rational investors are those investors that will
quickly buy any stocks that are priced too low and short-sell any stocks that are
priced too high.
An example of a rational consumer would be a person choosing between two

cars. Car B is cheaper than Car A, so the consumer purchases Car B.
While rational choice theory is logical and easy to understand, it is often

contradicted in the real world. For example, political factions that were in favor
of the Brexit vote, held on June 24, 2016, used promotional campaigns that were
based on emotion rather than rational analysis. These campaigns led to the
semi-shocking and unexpected result of the vote—the United Kingdom officially
decided to leave the European Union. The financial markets then responded in
kind with shock, wildly increasing short-term volatility, as measured by the CBOE
Volatility Index (VIX).

Rational behavior may not involve receiving the most monetary or material
benefit; the benefit of a particular choice could be purely emotional or non-
monetary. For example, while it is likely more financially beneficial for an
executive to stay on at a company rather than take time off to care for their new
newborn child, it is still considered rational behavior for them to take time off if
they feel that the benefits of the time spent with their child outweigh the utility
from the paycheck they receive.
Rational Choice Theory FAQs

What is rational choice theory?
The key premise of rational choice theory is that people don’t randomly select
products off the shelf. Rather, they use a logical decision-making process that
takes into account the costs and benefits of various options, weighing the options
against each other.
Who founded rational choice theory?

Adam Smith, who proposed the idea of an "invisible hand" moving free-market
economies in the mid-1770s, is usually credited as the father of rational choice
theory. Smith discusses the invisible hand theory in his book “An Inquiry into the
Nature and Causes of the Wealth of Nations,” which was published in 1776.
What are the main goals of rational choice theory?

The main goal of rational choice theory is to explain why individuals and larger
groups make certain choices, based on specific costs and rewards. According to
rational choice theory, individuals use their self-interests to make choices that will
provide them with the greatest benefit. People weigh their options and make
the choice they think will serve them best.
What is rational choice theory in international relations?

States, intergovernmental organizations, nongovernmental organizations, and
multinational corporations are all made up of human beings. In order to
understand the actions of these entities, we must understand the behavior of the
humans running them. Rational choice theory helps to explain how leaders and
other important decision-makers of organizations and institutions make
decisions. Rational choice theory can also attempt to predict the future actions of
these actors.
What are the strengths of rational choice theory?

One of the strengths of rational choice theory is the versatility of its application. It
can be applied to many different disciplines and areas of study. It also makes
reasonable assumptions and compelling logic. The theory also encourages
individuals to make sound economic decisions. By making sound economic
decisions, it is possible for an individual to acquire more tools that will allow them
to further maximize their preferences in the future.
The Bottom Line

The majority of classical economic theories are based on the assumptions of
rational choice theory: individuals make choices that result in the optimal level of
benefit or utility for them. Further, people would rather take actions that benefit
them versus actions that are neutral or harm them. Although many criticisms of
rational choice theory exist—because people are emotional and easily distracted,
and therefore, their behavior does not always follow the predictions of economic
models—it is still widely applied across different academic disciplines and fields
of study.

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What are the main assumptions of rational choice theory?

What are the main assumptions of rational choice theory?

What are some criticisms of rational choice theory?

What are some criticisms of rational choice theory?

Rational Choice Theory

What Is Rational Choice Theory?

 Rational choice theory states that individuals rely on rational calculations to

Rational choice theory is based on the assumption of involvement from rational

Economists may use this assumption of rationality as part of broader studies

Self-Interest and the Invisible Hand

According to the invisible hand theory, individuals driven by self-interest and

Advantages and Disadvantages of Rational Choice Theory

Behavioral economics attempts to explain—from a psychological perspective—

The Nobel laureate Herbert Simon, who rejected the assumption of perfect

Pros of Rational Choice Theory

 Can help to explain behavior that seems irrational

Cons of Rational Choice Theory

 People value some dollars more than others.

Examples of Rational Choice Theory

An example of a rational consumer would be a person choosing between two

While rational choice theory is logical and easy to understand, it is often

Rational Choice Theory FAQs

Who founded rational choice theory?

What are the main goals of rational choice theory?

What is rational choice theory in international relations?

What are the strengths of rational choice theory?

The Bottom Line

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