Loading the player...

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.

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.

  1. Rational Behavior

    A decision-making process that is based on making choices that ...
  2. Capital Rationing

    The act of placing restrictions on the amount of new investments ...
  3. Asset Rationalization

    Reorganizing a firm's assets in order to improve operating efficiencies ...
  4. Rationalization

    A reorganization of a company in order to increase its efficiency. ...
  5. Decision Theory

    Decision theory is an interdisciplinary approach to determine ...
  6. Financial Economics

    A branch of economics that analyzes the use and distribution ...
Related Articles
  1. Investing

    7 controversial investing theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  2. Trading

    This Is Your Brain On Stocks

    Find out how the human mind can hurt investors' portfolios.
  3. Financial Advisor

    Who is Richard Thaler, Economics Nobel Prize Winner?

    Thaler, one of the founding behavioral economists, won the 2017 Nobel Prize in Economic Sciences.
  4. Insights

    5 Nobel Prize-Winning Economic Theories You Should Know About

    Here are 5 prize-winning economic theories that you’ll want to be familiar with.
  5. Insights

    The Basics Of Game Theory

    Here we take an introductory look at game theory and the terms involved, and introduce you to a simple method of solving games, called backwards induction.
  6. Financial Advisor

    3 Reasons You're Crazy for Not Investing in Stocks

    It's been more than five years since The Great Recession officially ended. It's time to invest in the stock market again.
  1. What is the homo economicus?

    Homo economicus or "economic man" is the characterization of man in some economic theories as a rational person who pursues ... Read Answer >>
  2. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  3. Is a good's production cost related to its value?

    Learn about the history and debate regarding the metrics used to determine the value of a good and which theories place emphasis ... Read Answer >>
  4. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  5. What does the Efficient Market Hypothesis have to say about fundamental analysis?

    Find out what the efficient markets hypothesis has to say about fundamental analysis and how recent finance research has ... Read Answer >>
  6. Why is game theory useful in business?

    Once hailed as a revolutionary interdisciplinary phenomenon, game theory is actually applicable in today's business world. ... Read Answer >>
Hot Definitions
  1. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  2. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  3. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  4. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  5. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  6. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
Trading Center