Rational Choice Theory

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What is the 'Rational Choice Theory'

Rational choice theory is an economic principle that states that individuals always
make prudent and logical decisions. These decisions provide people with the
greatest benefit or satisfaction — given the choices available — and are also in
their highest self-interest. Most mainstream academic assumptions and theories
are based on rational choice theory.

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1. PARADOX OF RATIONALITY

2. ASSET RATIONALIZATION
3. HERBERT A. SIMON
4. BEHAVIORAL ECONOMICS

5.

BREAKING DOWN 'Rational Choice Theory'

Rational choice theory assumes that all people try to actively maximize their
advantage in any situation and therefore consistently try to minimize their losses.
The theory is based on the idea that all humans base their decisions on rational
calculations, act with rationality when choosing, and aim to increase either
pleasure or profit. Rational choice theory also stipulates that all complex social
phenomena are driven by individual human actions. Therefore, if an economist
wants to explain social change or the actions of social institutions, he needs to
look at the rational decisions of the individuals that make up the whole.
Arguments Against Rational Choice Theory
However, many economists do not believe in rational choice theory. Dissenters
have pointed out that individuals do not always make rational utility-maximizing
decisions. For example, the field of behavioral economics is based on the idea
that individuals often make irrational decisions and explores why they do so.

Additionally, Nobel laureate Herbert Simon proposed the theory of bounded

rationality, which says that people are not always able to obtain all the
information they would need to make the best possible decision. Further,
economist Richard Thaler's idea of mental accounting shows how people behave
irrationally by placing 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.

An Example Against Rational Choice Theory

While rational choice theory is clean 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, when 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).

Further, research conducted by Christopher Simms of Dalhousie University in

Halifax, Canada, shows that when people are anxious, they fail to make rational
decisions. Stressors that produce anxiety have been shown to actually suppress
parts of the brain that aid in rational decision-making.

Rational choice theory, also called rational action theory or choice

theory, school of thought based on the assumption that individuals choose a
course of action that is most in line with their personal preferences. Rational
choice theory is used to model human decision making, especially in
the context of microeconomics, where it helps economists better understand the
behaviour of a society in terms of individual actions as explained
through rationality, in which choices are consistent because they are made
according to personal preference. Rational choice theory increasingly is
applied to other areas as well, including evolutionary theory, political science,
and warfare.

Elements And Structure

In rational choice theory, agents are described by their unchanging sets of preferences
over all conceivable global outcomes. Agents are said to be rational if their
preferences are complete—that is, if they reflect a relationship of superiority,
inferiority, or indifference among all pairs of choices—and are logically ordered—
that is, they do not exhibit any cyclic inconsistencies. In addition, for choices in which
the probabilities of outcomes are either risky or uncertain, rational agents exhibit
consistencies among their choices much as one would expect from an astute gambler.
The consistency relations among preferences over outcomes are stated in
mathematical axioms; a rational agent is one whose choices reflect internal
consistency demanded by the axioms of rational choice. Rational choice theory holds
that all considerations pertinent to choice (that may include attitudes toward risk,
resentment, sympathy, envy, loyalty, love, and a sense of fairness) can be
incorporated into agents’ preference rankings over all possible end states. Social
scientists have only indirect access to agents’ desires through their revealed choices.
Therefore, researchers infer back from observed behaviour to reconstruct the
preference hierarchy that is thought to regulate a rational agent’s decisions.
Rational choice theory is a fundamental element of game theory, which provides a
mathematical framework for analyzing individuals’ mutually interdependent
interactions. In this case, individuals are defined by their preferences over outcomes
and the set of possible actions available to each. As its name suggests, game theory
represents a formal study of social institutions with set rules that relate agents’ actions
to outcomes. Such institutions may be thought of as resembling the parlour games
of bridge, poker, and tic-tac-toe. Game theory assumes that agents are like-minded
rational opponents who are aware of each other’s preferences and strategies. A
strategy is the exhaustive game plan each will implement, or the complete set of
instructions another could implement on an agent’s behalf, that best fits individual
preferences in view of the specific structural contingencies of the game. Such
contingencies include the number of game plays, the sequential structure of the game,
the possibility of forming coalitions with other players, and other players’ preferences
over outcomes.
For social scientists using game theory to model, explain, and
predict collective outcomes, games are classified into three groups: purely cooperative
games in which players prefer and jointly benefit from the same outcomes; purely
competitive games in which one person’s gain is another’s loss; and mixed games,
including the prisoner’s dilemma, that involve varied motives of cooperation and
competition. Game theory is a mathematical exercise insofar as theorists strive to
solve for the collective result of various game forms, considering their structure and
agents’ preferences. Equilibrium solutions are of the most interest because they
indicate, following the Nash equilibrium concept, that, given the actions of all other
agents, each agent is satisfied with his or her chosen strategy of play. Equilibrium
solutions have the property of stability in that they are spontaneously generated as a
function of agents’ preferences. Solving games is complicated by the fact that a single
game may have more than one equilibrium solution, leaving it far from clear what the
collective outcome will be. Moreover, some games have no equilibrium solutions
whatsoever.
A perplexing feature of game theory relates to the assumption of reflexivity on the
part of agents: agents must choose strategies in response to their beliefs of what
strategies others will choose. This idea of reflexivity leads some researchers to
associate methodological individualism with game theory. This is the assumption that
the individual is the pivotal unit of analysis for understanding collective outcomes in
politics and economics. However, as the use of game theory for understanding
interactions in populations studied in evolutionary biology makes clear, the
assumption of reflexivity and a view of the individual that could sustain a liberal
understanding of politics and economics are not essential. Still, having made this
observation, it remains the case that many who adopt game theory in social
sciencefind it consistent with individualistic approaches that view the individual as the
sole determinant of personal preferences, goals, and values. Among the outstanding
successes of rational choice theory in the late 20th century was its extensive
refashioning of understanding of how and why markets and democracy function to
respect individual choices.
Modeling Human Behaviour
The science of rational choice includes both research on the abstract conditions (or
norms) governing human rationality and research that seeks to explain and predict
outcomes assuming rational agency. There are two views on whether the theory
simply represents a descriptive means to model behaviour without presupposing that
agents actually reason in accordance with the theory or whether instead it actually
describes the decision rules manifested by rational agency. Researchers upholding the
first view generally are content to use the axioms of rational choice to model actions
and predict outcomes. The second view maintains that rational actors exhibit
purposive action consistent with the behavioral norms of rational choice. The first
view is modest by not suggesting anything about the internal thought processes of
agents, and the second view upholds rational choice theory as a theory that describes
the normative foundations of rational decision making. Even though the first view is
more restrained and is sufficient for applying rational choice methods to
understanding social and political phenomena, many researchers hold the view that
rational choice theory is a powerful analytic tool precisely because it reflects the
actual principles that must characterize purposive agency.
Rational choice theory has been central to methodological debates throughout the
social sciences because of its adherence to a limited view of human rationality as
consistency among preferences that categorically deems irrational modes of conduct
not reducible to this description. As with any robust research tradition, intense
controversies abound both internally and externally. Debates internal to the field have
tended to focus on complex nuances of the formal theory as well as the suitability of
associating consistency of choice with choices characterized by narrow self-interest.
Whereas the former is previously touched on, the latter attempt, for example, is to
determine if altruistic behaviour can be consistent with rational choice. Researchers
generally agree that altruistic preferences could be readily encompassed within
rational choice theory, but this leaves open the question of whether a satisfactory
concept of altruism can be reduced to agents’ preferences over outcomes.

Theory of rational choice

The dominant school of thought in political science in the late 20th century was rational choice theory.
For rational choice theorists, history and culture are irrelevant to understanding political behaviour;
instead, it is sufficient to know the actors’ interests and to assume that they pursue them rationally.
Whereas the earlier decision-making approach sought to explain the decisions of elite groups (mostly in
matters of foreign policy), rational choice theorists attempted to apply their far more formal theory
(which sometimes involved the use of mathematical notation) to all facets of political life. Many
believed they had found the key that would at last make political science truly scientific. In An Economic
Theory of Democracy (1957), an early work in rational choice theory, Anthony Downs claimed that
significant elements of political life could be explained in terms of voter self-interest. Downs showed
that in democracies the aggregate distribution of political opinion forms a bell-shaped curve, with most
voters possessing moderate opinions; he argued that this fact forces political parties in democracies to
adopt centrist positions. The founder of rational choice theory was William Riker, who applied economic
and game-theoretic approaches to develop increasingly complex mathematical models of politics. In The
Theory of Political Coalitions (1962), Riker demonstrated by mathematical reasoning why and how
politicians form alliances. Riker and his followers applied this version of rational choice theory—which
they variously called rational choice, public choice, social choice, formal modeling, or positive political
theory—to explain almost everything, including voting, legislation, wars, and bureaucracy. Some
researchers used games to reproduce key decisions in small-group experiments.

Rational choice theory identified—or rediscovered—at least two major explanatory factors that some
political scientists had neglected: (1) that politicians are endlessly opportunistic and (2) that all decisions
take place in some type of institutional setting. Rational choice theorists argued that political institutions
structure the opportunities available to politicians and thus help to explain their actions.
By the early 21st century, rational choice theory was being stiffly challenged. Critics alleged that it
simply mathematized the obvious and, in searching for universal patterns, ignored important cultural
contexts, which thus rendered it unable to predict much of importance; another charge was that the
choices the theory sought to explain appeared “rational” only in retrospect. Reacting to such criticisms,
some rational choice theorists began calling themselves “new institutionalists” or “structuralists” to
emphasize their view that all political choices take place within specific institutional structures. U.S.
congressmen, for example, typically calculate how their votes on bills will help or hurt their chances for
reelection. In this way, rational choice theory led political science back to its traditional concern with
political institutions, such as parliaments and laws. In more recent years, increasing numbers of rational
choice theorists have backed away from claims that their approach is capable of explaining every
political phenomenon.