Rational Choice Theory

Fundamentals of Market Investing by Adam J. McKee

Rational choice theory assumes that it is basic human nature that we try to maximize our advantage in any situation and consistently try to minimize our losses.  The theory is based on the idea that all humans base their decisions on rational calculations, act with rationality when making choices (financial or otherwise), and aim to increase profit (pleasure or reward).  Rational choice theory also specifies that all complex social phenomena are driven by individual human actions (e.g., Bentham’s “criminal calculus” in classical criminology).

If an economist, for example, wants to explain social change or the actions of social institutions, she needs to look at the rational decisions of the individuals that make up the whole.  Markets are no different.  Markets behave the way they do because of the collective action of market participants.  Under rational choice theory, the whole really is the sum of the parts.

The idea that we do what is best for us by making rational decisions is also called the principle of utility (and is the reason that the Utilitarians were so called).  In other words, human behavior is not accidental; it is a rationally designed to maximize utility (reward).  A major problem with the principle of utility is that people are not always very rational in the decisions that they make.  The field of behavioral economics is based on the idea that individuals often make irrational decisions and investigates why they do so.

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.  Most adherents to behavioral economics would argue that this is one possible reason that people make irrational choices, but there are potentially many others.  A major alternative is that people have the capacity for rationality, but that is not the way our brains make decisions most of the time.

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