Rational Choice Theory

In economics, rational choice theory (RCT) is a school of thought stating people’s decisions are based on rational analysis to achieve favorable outcomes. Individuals are calculating costs and benefits to determine which choices can maximize self-interest or are aligned with their beliefs.

RCT is a framework used in economics that assumes people are rational. Rationality refers to making efficient decisions to achieve the greatest benefit: If a person faces different choices, they will opt for the one that will provide the most benefit.

Now that we’ve identified rational choice theory, let’s dive deeper into its existence and how it works.

The rational choice theory was first introduced in 1776. Well-known economist, Adam Smith, proposed the theory in his book, “An Inquiry into the Nature and Causes of the Wealth of Nations.” Smith also helped developed the theory’s underlying principles. He used the metaphor, “invisible hand.”

The invisible hand explains how unseen forces influence free market economy. Under this, negative connotations of self-interest are refuted.

The theory believes that while rational actors consider their self-interest, they still create benefits for the economy and society as a whole. Thus, RCT has been used to understand behaviors of individuals and the society.

In economics, rational actors typically refer to consumers and firms.

There are various theories created to try to explain and understand human behavior. One of these is RCT. It’s used as a predictor of people’s choices. It also assumes quite a bit about the way people choose preferences and goals.

That said, many are disputing its relevance and role in society. Dissenters point out that rationality is not always the basis of decisions. Individuals are often affected by emotions and other external factors like status quo.

Among the fields that typically apply rational choice theory is economics. This theory is used to determine buying patterns and can help understand prices, demand and supply.

A good application can be seen in expected utility theory, which states that consumers make purchase decisions based on perceived utility or the satisfaction a product or service provides.

However, economics is only a primary application. Various fields have also adopted this framework to attempt to better understand and predict human behavior.

• Game theory: RCT is considered a fundamental element in game theory, which is used to provide a mathematical framework for the analysis of people’s mutually interdependent interactions. It studies social institutions that have set rules related to the actions of individuals to outcomes.
• Prospect theory: Prospect theory aims to incorporate observed violations to create a more descriptively valid framework when an individual makes decisions under risk. It involves two phases: The editing phase, where an individual edits prospects, and the evaluation phase, where a decision is made.
• Routine activities theory: A subsidiary of RCT, this theory gives a macro perspective on crime. It shows how changing conditions, both social and economic, can influence victimization and the overall crime rate.
• Politics: There are many ways RCT is applied in politics. Politicians may use it to determine the wants of their constituents. Governing bodies and agencies can determine prioritization of projects and policies based on the best interest of society. Additionally, politicians can use it to predict the actions of other leaders.
• Sociology: The application of RCT in sociology focuses on understanding what affects people’s decisions and the impact of these choices on others.

Among the aspects of life that highly involve decision-making is one’s finances. While behavioral finance believes that a person’s biases, rationales and emotions influence their financial decisions, RCT states that people are rational and unbiased.

The following examples of RCT violations can help you better understand its role in financial decision-making. This knowledge can help you gauge choices when making financial decisions and achieve the best results possible.

Professional managers often advise diversifying investments by buying from different sectors to hedge the risk. However, many investors tend to buy familiar stocks. A study by Gur Huberman (2001) shows familiarity bias amongst investors, where they buy stocks from local companies. For example, a U.S. citizen is much more likely to invest in a U.S. company, not because it’s a better bet, but because of the company's location.

This shows irrational decision-making. Instead of looking at one’s best interest by diversifying portfolios and buying global stocks, the investor decides based on bias. That means it’s a violation of RCT.

When it comes to loans, individuals tend to pay off smaller loans with low interest rates first before paying off larger loans with high interest rates. In a study, Dan Ariely and his team found that people would rather have fewer accounts than reduce their interest payments.

For example, an individual would rather pay off three small loans of $1,000 each and a 5% interest rate than a $50,000 loan with a 10% interest rate. In the three small loans, the borrower pays $150 interest annually but in the larger loan, they pay $5,000 in interest annually.

Having the desire to take care of small loans first is known as debt account aversion (DAA), which is a form of mental accounting.

This scenario is in violation of RCT. It shows irrationality because paying off larger loans first or starting with those with the highest interest rate and working to the lowest, as in the debt avalanche method, would help the individual save more money. The graph below shows how DAA increases as the interest rate of a debt increases.

Borrowing money can help businesses. However, taking out a loan is not always a great solution. In some cases, it may not even be a good option.

Despite this, many entrepreneurs and business professionals take out high-interest loans without having liquid cash in the bank. This is an irrational move and a violation of RCT.

For example, taking out a loan at 10% interest while liquid cash sits in your bank earning less than 1% interest hurts your wallet. That is why it’s important to compare a loan’s interest rate to your bank’s saving rate.

Having inconsistent preferences is not unusual. In fact, 73% of Americans said “they had regrets about their 2021 financial behaviors and decisions.”

Seasonal trends show the correlation between increasing household debt and holiday spending. Americans spent an average of $1,131 during the holiday season in 2021. That led to outstanding debt. In the chart below, you can see higher spending around the fourth quarter.

Credit card use also varies based on credit scores. For instance, people with exceptional credit were seen to put their largest spending on their credit cards. Additionally, only 17% of respondents had not paid off their holiday debts yet.

Many investors choose to sell profitable stocks to avoid losing stocks because they are afraid of recognizing loss and want to maximize benefits. That said, many also irrationally assume that stocks will increase back to the purchased price even if there is little evidence proving it.

Ritter (2003) provided the example of someone buying a stock at $30, which then drops to $22 before rising to $28. In such a case, most people don’t want to sell until the stock gets above $30. He regarded this investor bias toward winning stocks as the disposition effect.

The disposition effect, which was coined by Hersh Shefrin and Meir Statman, combines anchoring bias and mental accounting. It refers to traders’ tendency to prematurely sell assets that made gains more frequently while keeping assets that have lost their values. This behavior can be considered irrational and it violates RCT.

Money is fungible, which means it’s perfectly interchangeable. For example, people are willing to swap $1 for another $1 without knowing the difference. However, that may change depending on where the money came from.

Thaler (1999) found that consumers were willing to travel 20 minutes to another store to save $5 on a $15 calculator but not to save $5 on a $125 jacket. Following RCT, one should be willing to save $5 regardless of the purchased item. A person acting in their best interest would choose to travel to save $5, regardless of the cost of the original item.

However, in most cases, people view money in comparable terms. In the example given, the $5 savings on the calculator is seen as 33%. However, the $5 savings on the jacket is only 4%.

Dissenters of RCT argue that people tend to act according to emotion over probabilities. For instance, dying of heart disease is far more likely than dying in an airplane. According to the Centers for Disease Control and Prevention (CDC), approximately 659,000 people in the country die from heart disease every year. Meanwhile, the National Transportation Safety Board reported 349 fatalities from airplane crashes in 2020. Despite these probabilities, a lot of people fear flying but continue consuming high cholesterol foods.

Additionally, other factors can also affect a person’s fear of death. For example, money or the mere reminder of money can offer soothing effects to help people cope with the psychological terror that comes with the knowledge of mortality. Gasiorowska, et. al (2017) argued that money cues can activate self-esteem which can provide protection against mortality concerns.

Recent stories in the news can also cause people to inflate the probability of an outcome. For example, Blalock and his team (2009) found that after 9/11, people feared flying and decided to drive more.

While the probability of a car accident is far greater than an airplane crash, many concluded that driving was safer because 9/11 was recent and easily available in people’s minds.

According to RCT, people should not base decisions on irrelevant factors. For example, if a person wants the wine with the best taste, price should not influence their wine choice. Only the taste should matter. However, that is not how the human brain works. Cambridge University studied more than 6,000 blind tastings and people only preferred more expensive wine when they knew the price (Goldstein et al., 2008).

While the price of wine should have no effect on the taste, people can be irrational. When irrelevant factors influence preferences, there is a violation of the RCT.

An experiment conducted by Sox and Tversky showed that 50% of patients were more likely to opt for surgery when doctors described the outcome as having a 90% survival rate as opposed to a 10% death rate.

While the odd of dying are the same in both scenarios, the mere description of the surgery changed the patient’s preferences. Behavioral economists call this phenomena the framing effect and nudges individuals to violate RCT (Lewis, 2016).

Economic theories exist to find ways to understand how money organizes production distribution and consumption of products and services. For rational choice theorists, the same general principles can help understand human interactions wherein time, approval, information and prestige are exchanged.

The theory states that individuals have to make choices based on their goals and the means to attain said goals. Preferences are based on anticipated outcomes for each action. As rational actors, individuals will choose the course of action leading to the greatest result or satisfaction.

Knowing the definition of rational choice theory only gives you an overview of what the theory is all about. MoneyGeek answers some if the frequently asked questions (FAQs) about RCT to help you better understand what it is and how it can impact your daily life.

To further understand finance and economics, the following resources can help you learn more about other relevant terms and concepts.

• Understanding Supply: Supply refers to the amount of a certain good or service available to consumers at a given period and price level. It helps understand economic activities and determine patterns across products and services.
• Understanding Demand: Demand is the desire and willingness of consumers to purchase a good or service at a given period or over time. It helps understand consumer preferences and tastes.
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• Psychology of “Treat Yourself": Find out what the psychology of “treat yourself” is all about. Learn tips to manage splurges and create better spending habits.