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Rational Choice Theory: Definition, Pros, Cons & Examples

Written by Paul Boyce Posted in Behavioural Economics
Last Updated March 1, 2023

What is Rational Choice Theory

Rational choice theory is a concept that assumes people make rational choices which align to their own self-interest. Each individual is said to weigh up the cost and benefits of an economic decision and come to a rational choice. For instance, a customer pays too much for their gas and electric bill. There are many other companies that offer utilities cheaper. Rational choice theory suggests that the customer would do the rational thing and swap to a cheaper supplier.

Rational choice theory stipulates that each individual will look at the cost of making one decision over another, whilst also analyzing the benefit. In the end, humans are rational and so choose the option which provides them the most benefit.

This leads on to utility maximization. As humans are assumed to be rational, they will use their resources in a way by which their utility is maximized. For example, when faced with a decision of what brand of cereal to buy at the supermarket – the consumer will always choose the option which will give them the greatest level of utility. In plain English, the customer will always buy the product which they value – depending on their individual preferences.

Key Points

In rational choice theory, it is assumed that consumers weigh the costs and benefits and come to a rational conclusion.
Consumers will always choose the option which maximizes their utility.
Rational choice theory has applications in economics, political theory, and sociology.

In reality, rational choice theory does not always align well. For example, many customers end up with a rolling direct debit. It may be a magazine subscription or a subscription to a TV network channel. Each month, money is taken out of their account. They no longer want the service, but are not willing to cancel their membership.

Rational choice theory would suggest that if the consumer does not want the service, they won’t purchase it. Yet thousands of customers continue paying such subscription fees because they aren’t motivated enough to cancel them.

In some ways, this could be seen as rational behaviour. The small cost is deemed to be worth it in order to avoid to process of cancelling. Yet most firms offer a relatively simple way by which they can cancel their membership. This goes against the nature of rational choice theory. To spend a couple minutes to cancel the subscription could save hundreds of dollars each year. It is purely irrational to maintain such an expenditure for a service which is not even wanted.

Rational Choice Theory Explained

Rational choice theory states that individuals assess the impact of costs and benefits of each decision and choose the most rational option for their circumstances. That decision may be based on a number of variables such as:

Cost

Cost is a crucial factor to many of us. Those who are on lower incomes may be more sensitive to this variable, whilst those on high incomes may assign little weight to it. The cost of a good is the most explicit and can often demonstrate the products quality and trust. For instance, we often pay a premium price for branded goods because we trust in its quality. It can often be the defining factor of why we choose one good over another – which is particularly prevalent in homogenous goods such as insurance.

Information

When making a decision, information is a key component. For example, when deciding what type of laptop to buy, the consumer may need to look up what the terminology means. How much storage do they need and how important is a graphics disk? Such information helps the consumer make a rational decision based on their individual preferences.

Prestige

Many consumers will base their purchasing decision on the prestige of the good they are buying. For instance, consumers may buy the latest Gucci handbags in order to impress their friends and maintain their social standing. Alternatively, they may drive around in a flashy sports car. Whatever it is, the prestige of a purchasing decision may outweigh other factors.

Risk

In markets such as insurance, risk can be an influential factor. For example, some individuals may be more risk-adverse than others. Some may prefer the peace of mind that their mobile phone is covered should they accidentally drop it down the toilet. Others may feel that they don’t need the cover and are happy to take on the risk instead.

Time

Time can be a crucial factor for many. When deciding between two options, time can be of great value. After all, we only have a limited 24 hours each day, so if it saves time, it can be worthwhile. Each of us values time differently. Perhaps we value leisure time greater than working an extra hour for $20. Or, we may value an overpriced snack because it saves us time from going to the cheaper store down the road.

Often, those with higher levels of wealth can pay a greater premium to save time. For instance, they may have more meals out to save them time from cooking. And for the extremely rich, they may have private jets which can fly them straight to their next location.

Rational Choice Theory Examples

The very essence of rational choice theory lies on the principle that individuals weigh up the costs and benefits and come to a rational conclusion. Examples include:

Choosing to walk instead of drive

Susan works down the road at a local supermarket. It is around 30 minutes to walk, but only 5 minutes to drive. The cost to Susan is that she has to spend an extra 25 mins of her time walking. However, she benefits from the costs she saves on fuel, and the exercise she gets in the process. The conclusion she comes to is deemed rational as it is dependent on her own individual values and preferences. Just because it may seem an irrational choice for one, does not make it so for another.

Investor choosing one shares over another

Most investors will take time to look through a share’s recent performance and its annual financial statements. The aim is to obtain enough information to determine if it’s likely to make them a profit. Now not all investments pay off, but the individual is being rational by looking at the company’s previous performance.

They are likely to factor in the cost and the predicted price or return over the course of x number of years. Therefore, are the potential returns worth the associated risk? If the answer is yes, then the investor will choose those shares. Yet the return may not pay off and they end up losing money. Nevertheless, it is still a rational decision in the fact that the cost (the risk) is deemed to be worth the potential benefit.

Choosing to stay after school to study

Students often face themselves with this common dilemma. Do they spend two hours after school studying and sacrifice their leisure time? That way, they may be able to achieve better grades and go on into a better university/college. Alternatively, they can just spend it on leisure and hope it doesn’t affect their grades.

Staying after school may benefit the student in the long run if it helps them obtain better grades. However, it may equally affect their mental health if they are unable to get some downtime. In turn, this may in-directly affect their grades. So the rational option is not necessarily the most obvious. It purely depends on the individual and their own preferences.

Cons of Rational Choice Theory

1. Inadequate Information

One of the main issues with rational choice theory is that it assumes the individual has perfect information. This works well in theory, but in practice, the consumer never has such a complete understanding. For example, when a consumer buys a car, they don’t necessarily have all the information available to them. This is particularly the case for second hand cars where the consumer may not know of any faults.

2. Cognitive Limitations

Even when consumers have perfect information, rational choice theory assumes that we all have the capacity to analyze the costs and benefits. However, whilst humans are perhaps the most intelligent beings in the world – we still have cognitive limitations. For example, most of us would need a pen and paper to calculate 537 x 328. Even then, it may take us a while to work out. Transfer this over to complex decision making and we will frequently make the wrong decision.

3. Time

When making a decision, we are naturally constrained by the level of information we have, as well as our own cognitive abilities. Yet we are also restrained by time. For example, a patient may face the option of two different types of surgery. Both have different chances, but both also have different levels of effectiveness. As a patient, they have one day to decide. If they had a month, they may be able to gather all the information and have the cognitive ability to make a rational choice. Yet this is not afforded to them due to time constraints – so a sub-optimal choice may be chosen.

4. Consistency

Many consumers will have the same products they like to buy each and every week. They may become accustomed to buying the same cereal and do so without even thinking about it. Yet even though it may be their favorite cereal, they may not have tried all the others available. They are consistent with their previous purchasing habits – which can be a crucial factor, particularly in markets such as utilities and insurance, whereby consumers often stick with their existing providers.

5. Social Pressures

At some point or another, we have chosen to do something against our will in order to conform to social norms and pressures. Even though we do not want nor intended to, we do so anyway. For example, gift giving during the seasonal period is frequently done despite many gifts being unwanted. It’s irrational to buy gifts for each other that neither wants. Yet it has become a social tradition. By contrast, rational choice theory argues that these are in fact rational choices because they are done in order to fit in with social norms. The cost of not doing so is social exclusion, which is deemed a worse outcome than the cost of the gift.

6. Heuristics

A heuristic is essentially a way in which our brain processes information to make its job easier. Yet on occasions, this can lead to suboptimal and irrational decisions. One common example is the availability heuristic. For example, we may see a recent plane crash in the news. In turn, this affects our perception of how likely it is to occur.

As this is new information for us, it takes a greater precedence over the actual likelihood of a plane crash. So although the likelihood of a plane crash is 1 million to one, the recent news of a crash makes us believe it is even one thousand to one. In turn, it can lead to irrational choices based on exaggerated information.

Pros of Rational Choice Theory

Rational choice theory has application in many fields ranging from economics to politics to sociology. Its use has had many benefits throughout these fields and has advanced our understanding of human decision behavior. At the same time, it is the most advanced general theory of social action available. So whilst it may have many criticisms, its application can help explain the vast majority of human actions. The benefits of rational choice theory can be summarized as;

1. Explains Irrational Behavior

Rational choice theory assumes that each individual makes a rational decision. This helps us move on from just assuming an individual makes an irrational decision. For example, employees may go out to their employers Christmas party each year. However, many do not want to go. They may have to be careful what they say or do – after all, they are with colleagues and their managers. Yet they go despite not wanting to. This seems like an irrational decision – doing something they don’t want.

However, rational choice theory questions the assumption that this is an irrational choice. This is because the employee is faced with costs and benefits. The cost of not going may lead to social ostracization in the work place or impact on their promotion chances. Therefore, the benefit of advancing social connections often outweighs the disadvantage of having to endure the works Christmas party.

2. Predictive

Rational choice theory has helped produce a wide number of theories in a whole host of different fields. It has helped reduce the wide range of likely human actions to more defined outcomes. Each individual action is seen to be rational based on the cost and benefits of that decision. So this is considered when looking at predicting human actions.

It has helped economists’ base theories around this assumption. For example, supply and demand dictates that when prices rise, demand falls. And when prices fall, demand increases – which is based on the idea that individuals make rational decisions. Human actions will tend to fall into a set number of buckets, which helps those in the social sciences predict outcomes.

3. Generalized Human Behavior

Rational choice theory extends beyond its original use within the social sciences. Not only is it used to analyze consumer behavior and economic decision making, but also far-reaching behavior with relation to choices such as education, marriage, child-bearing, and political matters. It also extends to business decisions about the level of output, investment decisions, hiring decisions, and many others.

Rational choice theory applies to all these areas of life and covers human actions through many applications. And more often than not, it is an accurate representation of human action.

FAQs on Rational Choice Theory

What is the rational choice theory?

Rational choice theory is the concept that each individual comes to a rational decision after weighing of the cost and benefits.

What is the purpose of rational choice theory?

The purpose of rational choice theory is to model human behavior so social scientists can better understand the behavior of individuals and society as a whole.

What is wrong with rational choice theory?

There are many criticisms with rational choice theory. The most prominent of which is that humans are naturally irrational and take emotionally charged decisions. For example, after an argument, an individual may go out for a drive and perhaps drive too fast down the highway, thereby causing an accident.

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.