Last editedJan 20212 min read
Any definition of rational choice theory begins and ends with the idea that people make rational decisions based on a sensible calculation of a situation. Under rational choice theory these decisions are made because they are the most likely to achieve the personal objectives of the individual in question. In simple terms, rational choice theory leads to people making the right choice, because the right choice is the one that offers the most satisfaction and the surest benefit.
How is rational choice theory applied?
In the area of mainstream economics – the kind of economic policies pursued by democratically elected governments around the world – rational choice theory provides the foundation they base decisions upon. Other ideas you’re likely to come across when studying the impact of rational choice theory include the following:
Rational actors – individuals making rational choices based on the information available
The rationality assumption – the thinking applied by economists when trying to understand how society behaves
The invisible hand – the idea that individuals acting rationally in their own self-interest will benefit the wider economy as a whole
Rational choice theory works on the assumption that individuals within a society behave in a rational manner. In practice, this means they make use of the maximum amount of rational information they can access and, in any given situation, use that knowledge in order to minimize losses and maximize their advantages.
Once this assumption has been made with regard to individuals, economists then use rational choice theory to develop theories and understanding in terms of the behavior of the whole of society.
What is the invisible hand?
The theory of the invisible hand was first put forward by economist Adam Smith in 1776 in his book, “An Inquiry into the Nature and Causes of the Wealth of Nations.” It forms the basis of much of the thinking around rational choice theory.
The invisible hand theory and some of the other ideas around rational choice theory that have emerged since then attempt to deal with the negativity that often surrounds the concept of acting out of self-interest. Economists who believe in rational choice theory and the concept of the invisible hand tend to argue that governments should intervene in the economy as little as possible, which will enable the free market to flourish.
Potential weaknesses of rational choice theory
Although rational choice theory is popular with some economists, many others do not believe in it, and for that reason do not promote polices that align with the invisible hand theory. Economists who disagree with rational choice theory highlight that individuals can’t always be relied on to make rational decisions that will deliver the maximum benefits. This perspective enables them to study what happens when individuals take decisions that are both rational and irrational.
Alternatives to rational choice theory
One of the alternatives to rational choice theory put forward by economists is the concept of bounded rationality. This was first proposed by Herbert Simon, a Nobel laureate, and it works on the assumption that individuals won’t always be able to access the kind of information needed to make a genuinely informed and effective decision.
Another alternative was proposed by economist Richard Thaler. He coined the term “mental accounting” to describe the fact that people often irrationally place greater value on some dollars when compared to others, which is irrational since all dollars, by definition, have the same value. One example he gives is that an individual might travel to a specific store to save $10 on a $20 purchase, but not to save the same $10 on a $1,000 purchase. The price of the purchase distorts the way the individual thinks of the value of the $10 they are able to save.
Along similar lines, research carried out by Christopher Simms of Dalhousie University in Halifax, Canada, found that individuals in a state of anxiety are much less likely to make rational decisions. Further research has shown that the chemicals within the brain that trigger anxiety can also suppress the parts of the brain that help with rational decision making.
We can help
If you want to make the best possible decisions for your business then get in touch with the experts at GoCardless. You can find out how GoCardless can also help you with ad hoc payments or recurring payments.