The rational choice theory suggests that individuals always choose the options that maximize their self-interest and provide them with the maximum level of satisfaction. It is assumed according to the theory that all decision-makers think rationally and only invest in something as long as they expect its return to be more than its cost. This theory has also received a lot of criticism due to its limitations. In this article, we shall discuss the theory of rational choice in detail and also discuss the advantages and disadvantages of this theory.
Understanding Rational Choice Theory: Assumptions, Example, Criticism
The approach of rational choice suggests that individuals make their decisions based on some rational and planned calculations to make reasonable choices regarding their spending and savings to achieve results that take them closer to their ambitions and targets. These goals and targets are set in a manner that maximizes the individual’s self-interest. The theory suggests that people strive to maximize their profits and want to gain an optimal amount of benefit and satisfaction from their decisions. Adam smith who is also known as the father of classical economics laid the first foundation for this theory.
Many famous theories of economics consider the approach of rational choice as an assumption. The approach of rational choice focuses on the self-interest of individuals, the invisible hand and many other rational actors that influence the decisions of people. This approach highlights the involvement of rational actors. Rational actors are all the individuals in the economy who carefully calculate and analyze all the available information before making any decisions.
In a very famous book “An inquiry into Nature and Causes of the wealth of the nations” written in the year 1776, Adam Smith explained the topics of self-interest and the invisible hand in detail. The invisible hand is a term used to represent all the invisible and unknown forces that influence the free market. He explained the concept of self-interest and to acting in a way to benefit one’s self is not negative at all, and this concept has been misconstrued. Instead, if people act in their self-interest, then in the long run it can be greatly beneficial for the overall economy.
According to the concept of an invisible hand, individuals strive to maximize their returns and satisfaction and if they think rationally and analyze all the factors before making decisions then it can turn out to be very profitable. Economists who support the theory of the invisible hand advocate for lesser government intervention in the market. They rather suggest that the market can stabilize itself and the pressure from supply and demand is enough to keep the market at equilibrium.
Some assumptions set the foundation for the theory of rational choice, some of these assumptions are as follows:-
- All the decisions made by individuals are rational and they are made after taking into consideration all the costs and profits. The consequences of the actions are also taken into consideration by the decision-maker.
- The cost of the action must always be less than the reward. For example, people invest in stocks that they expect profits from.
- An individual is most likely to invest in a relationship or asset until the reward remains higher than the cost. When the rewards start to decline and eventually become less than the cost, that is when the individual will no longer invest in it.
- Individuals use their resources and all the available assets to achieve optimal benefits and results.
One of the major examples of rational choice theory is the behaviour of investors in the stock market. Rational investors are the investors who analyze their decisions and are quick to buy stocks that they think might be underpriced and they tend to sell the stocks that they deem overpriced. The important thing here is to remember that the rational choice theory emphasizes the maximum satisfaction of the individual, it is not important that the benefit is only monetary it can also be purely emotional.
A very solid argument against the theory of rational choice is that it does not apply to every individual. There is a limited number of individuals in every society who think rationally and make their decisions after calculating the cost and the expected reward. Humans are naturally more emotionally inclined, and they make decisions based on their moods, emotions, and values. Also, another big gap in the theory according to many economists is that the theory does not give any reasoning about context-dependent decisions. People react differently in different situations. Hence, the external factors impacting the decision-making process cannot be neglected.
The biggest advantage of the rational choice theory is its diversity, the theory covers the most basic principle of human behaviour and hence it can be applied to many aspects of life. This theory just provides a very basic and simple explanation of how individuals make their decisions based on what they think will satisfy them the most. Not only this theory provides evidence about how people analyze all factors and available information before making decisions, but it also explains that it is not important that individuals seek monetary benefits but sometimes their decisions are backed by emotions and sentiments, and such decisions may seem irrational to other people.
The disadvantage of this theory is that it does not apply to everyone because not all individuals are rational decision-makers. Some people make their decisions impulsively without analyzing the available information. Hence, this theory does not provide us with a clear picture of how consumers behave and how they make choices. Different people have different priorities and goals in life, some people have more value for money and materialistic things than others. Hence, using this theory consumer behaviour cannot be predicted.
Also, the literacy and intellectual level of all individuals are different. Hence, all individuals analyze the given information differently. Some people are not capable of studying the available information and hence they make decisions based on their intuitions or emotions.
To conclude, the theory of rational choice explains the basic rule of human behaviour, that all individuals make decisions that maximize their self-interest. People have different goals and ambitions and keeping in mind their targets they tend to move forward in life. The theory assumes that all individuals are rational choice-makers, which implies that everyone analyses all internal and external factors, consequences, and rewards before making any decision. This theory sets the base for many other economic theories but at the same time, many economists have criticized its application.