- Rational choice theory is a framework that states that individuals behave according to their own self-interests.
- Adam Smith created the foundation of rational choice theory using a metaphor known as the 'invisible hand' to explain outcomes based on self-interest.
- The theory assumes there are 'rational actors' and doesn't account for cultural nuance, emotions, or unconscious behavior.
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Every day, you make many decisions that affect your life and finances. Rational choice theory proposes that individuals work as 'rational actors' and base decisions on what makes the most sense economically and for their personal interests. This theory is also sometimes referred to as choice theory or rational action theory and helps predict certain behavioral outcomes.
What is rational choice theory?
Rational choice theory is a framework used in economics and other fields of study that proposes that individuals make decisions that are based on maximizing their own benefits. The theory suggests that people perform a cost-benefit analysis and make decisions based on their personal interests.
"Rational choice theory assumes that individuals will carefully evaluate all decisions, weighing the costs and benefits of each potential path forward, and then choosing what they believe will maximize the benefit to themselves," says Nicholas B. Creel, M.A, J.D., LL.M., Ph.D. and assistant professor of business law at Georgia College and State University.
Economist Adam Smith originally came up with the foundation for rational choice theory as expressed in "An Inquiry into the Nature and Causes of the Wealth of Nations" in 1776. He used the term 'invisible hand' as a metaphor to illustrate the hidden forces in economic behavior, such as pursuing one's own self-interest.
As a whole, rational choice theory is used in economics to predict particular outcomes and behaviors. It's based on the idea that people will make decisions that benefit them and are based on their preferences.
The theory proposes that individuals consider monetary gains as well as losses in their decision-making. However, many people strive toward avoiding any losses rather than seek out gains in something referred to as "loss aversion."
How is rational choice theory applied?
Rational choice theory is used in a variety of different fields to make predictions around human behavior.
- In business as well as the economic sectors, it's used to predict consumer purchasing.
- In psychology and sociology, it's used to predict how and why people behave a certain way.
- In addiction management, rational choice theory is used to explain the inherent motivations by using or consuming a substance and looks for alternatives that can provide similar outcomes.
- In the political sector, it's used to predict voting patterns and explain how and why a politician behaves in a certain way.
Though the theory may have started as a way to explain consumer behavior, it's now used in various fields as a way to offer insight into human behavior and predict certain outcomes.
What is the invisible hand?
The idea of the "invisible hand" is the foundation for rational choice theory.
"The invisible hand is a concept first discussed by Adam Smith. The core idea behind it is that each individual acts in their own best self interest in a way that maximizes their welfare, better so than any outsider acting on their behalf could," says Creel.
The idea is used as a metaphor to explain why we behave the way we do and that we are guided by self interest, even if we're not aware of it.
When it comes to investing and finance, rational choice theory supposes that people will make decisions that maximize benefits and minimize losses.
Pros and cons of the rational choice theory
Rational choice theory is used in a wide range of fields for different reasons. Though the theory can be useful and offer important insights, it also lacks some nuance as well.
"[Rational choice theory] helps a business create a buying persona and understand consumer behavior based on their 'rational choices,'" says Nemeroff.
But also that isn't the whole picture. According to Nemeroff rational choice theory also "oversimplifies and makes a lot of assumptions which can put a business at risk. It is usually better to derive actions and results based on actual data."
Some pros and cons of rational choice theory are:
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Pros |
Cons |
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It's a useful tool to explain individual and collective behavior in economics, business, and more. |
It assumes that people are always 'rational,' which doesn't account for emotions or unconscious behavior. |
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It provides a framework of understanding for behavior that may appear irrational, but in the end is self-serving. |
It oversimplifies human behavior, when everything isn't explained with logic. |
|
It can be used to predict outcomes and behavior. |
It doesn't provide cultural context or nuance regarding difference and may appear biased. |
"The biggest strength of rational choice theory is that it allows us to simplify what we know is an incredibly complex human behavior," says Creel.
Creel explains that though it can simplify things — it does just that — simplifies it to the point where there is a lack of nuance, especially as it relates to cultural context and difference. "Rational choice theory assumes that human behavior would be universally explained by it, so the sort of variation shouldn't happen if it was a sound explanation of how we as a species make our decisions," he says.
The financial takeaway
Rational choice theory is a way to look at the motivations and behavior of individuals and society. On the surface, it makes sense that many of our choices are based on self-interest and maximizing benefits while reducing costs. This theory can be applied in many ways in different fields of study to predict certain results.
However, the theory doesn't account for important nuances as it relates to emotions, unconscious behavior, and more. Despite this, rational choice theory is still used in a range of fields and can be useful for predicting consumer behavior.