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This page is about a theory of economics. For Rational Choice Theory as applied to criminology, see Rational choice theory (criminology).

Rational Choice Theory, also known as Choice Theory or Rational Action Theory, is a framework for understanding and often formally modeling social and economic behavior. Rationality, interpreted as "wanting more rather than less of a good", is widely used as an assumption of the behavior of individuals in microeconomic models and analysis and appears in almost all economics textbook treatments of human decision-making. It is also central to some of modern political science, sociology, and philosophy. It attaches "wanting more" to instrumental rationality, which involves seeking the most cost-effective means to achieve a specific goal without reflecting on the worthiness of that goal. Gary Becker was an early proponent of applying rational actor models more widely. He won the 1992 Nobel Memorial Prize in Economic Sciences for his studies of discrimination, crime, and human capital.

The "rationality" described by rational choice theory is different from the colloquial and most philosophical use of the word. Typically, "rationality" means "sane" or "in a thoughtful clear-headed manner,." Rational choice theory uses a specific and narrower definition of "rationality" simply to mean that an individual acts as if balancing costs against benefits to arrive at action that maximizes personal advantage. In rational choice theory, all decisions, crazy or sane, are postulated as mimicking such a "rational" process. Thus rationality is seen as a property of patterns of choices, rather than of individual choices: there is nothing irrational in preferring fish to meat the first time, but there is something irrational in preferring fish to meat and preferring meat to fish, regularly.

Work done under the rational choice theory paradigm typically does not investigate the origins, nature, or validity of human motivations (why we want what we want). Instead, it takes the biological, psychological, sociological, moral, and ethical roots of behavior and preferences as given and theorizes with these factors fixed.

Because rational choice theory lacks understanding of consumer motivation, some economists restrict its use to understanding business behavior where goals are usually very clear. As Armen Alchian points out, competition in the market encourages businesses to maximize profits (in order to survive). Because that goal is significantly less vacuous than "maximizing utility" and the like, rational choice theory is apt.

Although models used in rational choice theory are diverse, all assume individuals choose the best action according to unchanging and stable preference functions and constraints facing them. Most models have additional assumptions. Those proponents of rational choice models associated with the Chicago school of economics do not claim that a model's assumptions are a full description of reality, only that good models can aid reasoning and provide help in formulating falsifiable hypothesis, whether intuitive or not. In this view, the only way to judge the success of hypothesis is empirical tests. To use an example from Milton Friedman, if a theory that says that the behavior of the leaves of a tree is explained by their rationality passes the empirical test, it is seen as successful.

Daniel Kahneman

However, it may not be possible to empirically test or falsify the rationality assumption, so that the theory leans heavily toward being a tautology (true by definition) since there is no effort to explain individual goals. Nonetheless, empirical tests can be conducted on some of the results derived from the models. In recent years the theoretical vision of rational choice theory has been subject to more and more doubt by the experimental results of behavioral economics. This criticism has encouraged many social scientists to utilize concepts of bounded rationality to replace the "absolute" rationality of rational choice theory: this points to the difficulties of data-processing and decision-making associated with many choices in economics, political science, and sociology. More economists these days are learning from other fields, such as psychology, in order to get a more accurate view of human decision-making than offered by rational choice theory. For example, the behavioral economist and experimental psychologist Daniel Kahneman won the Nobel Memorial Prize in Economic Sciences in 2002 for his work in this field.

Because of the relative success of economics at understanding markets, rational choice theory has also become increasingly employed in social sciences other than economics, such as sociology and political science in recent decades. It has had far-reaching impacts on the study of political science, especially in fields like the study of interest groups, elections, behaviour in legislatures, coalitions, and bureaucracy. Models that rely on rational choice theory often adopt methodological individualism, the assumption that social situations or collective behaviors are the result of individual actions alone, with no role for larger institutions. The poor fit between this and sociological conception of social situations partially explains the theory's limited use in sociology. Among other things, sociology's emphasis on the determination of individual tastes and perspectives by social institutions often conflicts with rational choice theory's methodological assumption that tastes and perspectives are given and static.

Actions, assumptions, and individual preferences

The basic idea of rational choice theory is that patterns of behavior in societies reflect the choices made by individuals as they try to maximize their benefits and minimize their costs. In other words, people make decisions about how they should act by comparing the costs and benefits of different courses of action. As a result, patterns of behavior will develop within the society that result from those choices.

The idea of rational choice, where people compare the costs and benefits of certain actions, is easy to see in economic theory. Since people want to get the most useful products at the lowest price, they will judge the benefits of a certain object (for example, how useful is it or how attractive is it) compared to similar objects. Then they will compare prices (or costs). In general, people will choose the object that provides the greatest reward at the lowest cost.

Rational decision making entails choosing a "rational" action given one's preferences, the actions one could take, and expectations about the outcomes of those actions. Actions are often expressed as a set, for example a set of j exhaustive and exclusive actions:

$A=\{a_{1},\ldots ,a_{i},\ldots ,a_{j}\}$

For example, if a person is to vote for either Roger or Sara or to abstain, their set of possible voting actions is:

$A=\{Roger,Sara,abstain\}$

Individuals can also have similar sets of possible outcomes. By making some reasonable assumptions about the way choices behave, von Neumann and Morgenstern showed that if an agent can choose between the lotteries, then this agent has a utility function which can be added and multiplied by real numbers, which means the utility of an arbitrary lottery can be calculated as a linear combination of the utility of its parts.

This is called the expected utility theorem. The required assumptions are four axioms about the properties of the agent's preference relation over 'simple lotteries', which are lotteries with just two options. Writing B\preceq A to mean 'A is weakly preferred to B' ('A is preferred at least as much as B'), the axioms are: 1.completeness: For any two simple lotteries \,L\, and \,M\,, either L\preceq M or M\preceq L (or both). 2.transitivity: for any three lotteries L,M,N, if L\preceq M and M\preceq N, then L\preceq N. 3.convexity/continuity (Archimedean property): If L \preceq M\preceq N, then there is a \,p\, between 0 and 1 such that the lottery \,pL + (1-p)N\, is equally preferable to \,M\,. 4.independence: for any three lotteries L,M,N, \,L \preceq M\, if and only if \,pL+(1-p)N \preceq pM+(1-p)N\,.

In more formal language: A von Neumann–Morgenstern utility function is a function from choices to the real numbers: u : X \rightarrow \textbf{R} which assigns a real number to every outcome in a way that captures the agent's preferences over simple lotteries. Under the four assumptions mentioned above, the agent will prefer a lottery L_2 to a lottery L_1 if and only if the expected utility of L_2 is greater than the expected utility of L_1: L_1\preceq L_2 \; \mathrm{iff} \; u(L_1)\leq u(L_2). Repeating in category language: u is a morphism between the category of preferences with uncertainty and the category of reals as an additive group.

Of all the axioms, independence is the most often discarded. A variety of generalized expected utility theories have arisen, most of which drop or relax the independence axiom. CES (constant elasticity of substitution, or isoelastic) utility is one with constant relative risk aversion Exponential utility exhibits constant absolute risk aversion

Rational choice theory makes three assumptions about individuals' preferences for actions:

• Completeness– all actions can be ranked in an order of preference (indifference between two or more is possible).
• Transitivity – if action a₁ is preferred to a₂, and action a₂ is preferred to a₃, then a₁ is preferred to a₃. In other words, all actions can be compared with other actions.
• Independence of irrelevant alternatives - If A is preferred to B out of the choice set {A,B}, then introducing a third alternative X, thus expanding the choice set to {A,B,X}, must not make B preferable to A.

Together these assumptions form the result that given a set of exhaustive and exclusive actions to choose from, an individual can rank them in terms of his preferences, and that his preferences are consistent.

An individual's preferences can also take forms:

• Strict preference occurs when an individual prefers a₁ to a₂, but not a₂ to a₁.
• In some models, a weak preference can be held in which an individual has a preference for at least a_j, similar to the mathematical operator ≤.
• Indifference occurs when an individual does not prefer a₁ to a₂, or a₂ to a₁.

In more complex models, other assumptions are often incorporated, such as the assumption of independence axiom. Also, with dynamic models that include decision-making over time, time inconsistency may affect an individual's preferences.

Other assumptions

It is often claimed that rational choice theory makes some unrealistic assumptions in order to generate tractable and testable predictions. These can include:

• An individual has full or perfect information about exactly what will occur due to any choice made. More complex models rely on probability to describe outcomes.
• An individual has the cognitive ability and time to weigh every choice against every other choice. Studies about the limitations of this assumption are included in theories of bounded rationality.

Even more realistic theories of human action include such components as Amos Tversky and Daniel Kahneman's prospect theory, which reflects the empirical finding as that, contrary to rational choice theory, individuals attach extra value to items that they already own compared to similar items owned by others. To rational choice theory, the amount that an individual is willing to pay for an item (such as a drinking mug) should equal the amount he or she is willing to be paid in order to part with it. In experiments, the latter price is typically significantly higher than the former. Behavioral economics includes a large number of other amendments to its picture of human behavior that go against pure economic rationality.

Utility maximization

Often preferences are described by their utility function or [payoff function]. This is an ordinal number an individual assigns over the available actions, such as:

$u\left(a_{i}\right)>u\left(a_{j}\right)$

The individual's preferences are then expressed as the relation between these ordinal assignments. For example, if an individual prefers the candidate Sara over Roger over abstaining, their preferences would have the relation:

$u\left(Sara\right)>u\left(Roger\right)>u\left(abstain\right)$

It was recognized that utility could not be measured or observed directly, so instead economists devised a way to infer underlying relative utilities from observed choice. These 'revealed preferences', as they were named by Paul Samuelson, were revealed e.g. in people's willingness to pay:

Utility is taken to be correlative to Desire or Want. It has been already argued that desires cannot be measured directly, but only indirectly, by the outward phenomena to which they give rise: and that in those cases with which economics is chiefly concerned the measure is found in the price which a person is willing to pay for the fulfilment or satisfaction of his desire. (Marshall 1920:78)[1]

Utility is usually applied by economists in such constructs as the indifference curve, which plot the combination of commodities that an individual or a society would accept to maintain a given level of satisfaction. Individual utility and social utility can be construed as the value of a utility function and a social welfare function respectively. When coupled with production or commodity constraints, under some assumptions, these functions can be used to analyze Pareto efficiency, such as illustrated by Edgeworth boxes in contract curves. Such efficiency is a central concept in welfare economics.

In finance, utility is applied to generate an individual's price for an asset called the indifference price. Utility functions are also related to risk measures, with the most common example being the entropic risk measure

Criticism

Both the assumptions and the behavioral predictions of rational choice theory have sparked criticism from various camps. As mentioned above, some economists have developed models of bounded rationality, which hope to be more psychologically plausible without completely abandoning the idea that reason underlies decision-making processes. Other economists have developed more theories of human decision-making that allow for the roles of uncertainty, institutions, and determination of individual tastes by their socioeconomic environment (cf. Fernandez-Huerga, 2008).

Martin Hollis and Edward J. Nell's 1975 book offers both a philosophical critique of neo-Classical economics and an innovation in the field of economic methodology. Further they outlined an alternative vision to neo-Classicism based on a rationalist theory of knowledge. DON C. LAVOIE (1977, p. 325) argued that

To the devastating critiques of positivism by such philosophers as Brand Blanshard, W. V. Quine, S. Toulmin, A. R. Lousch and Karl Popper, can now be added that of Professors Hollis and Nell. The reason for the impotence of modern economics, these authors show, lies in its method. The rejuvenation of economics necessitates developing a different methodology, one which pays attention to the aspects of social sciences which distinguish them from natural sciences. We need a method which recognizes that people are not atoms and that society is not a laboratory.

Hollis and Nell (1975) dissect the textbook combination of neo-Classicism and Positivism, so crucial to the defence of orthodox economics against now-familiar objections. Within Neo-classicism, the authors addressed consumer behaviour (in the form of indifference curves and simple versions of revealed preference theory) and marginalist producer behaviour in both product and factor markets. Both are based on rational optimizing behaviour. They consider imperfect as well as perfect markets since neo-classical thinking embraces many market varieties and disposes of a whole system for their classification. However, the authors believe that the issues arising from basic maximizing models have extensive implications for econometric methodology (Hollis and Nell, 1975, p. 2). In particular it is this class of models – rational behavior as maximizing behaviour – which provide support for specification and identification. And this, they argue, is where the flaw is to be found. Hollis and Nell (1975) argued that Positivism (broadly conceived) has provided neo-Classicism with important support, which they then show to be unfounded. But we shall argue that they base their critique of neo-Classicism not only on their critique of Positivism but also on the alternative they propose, Rationalism. Indeed, they argue that rationality is central to neo-Classical economics – as rational choice – and that this conception of rationality is misused. Demands are made of it that it cannot fulfil.

In their 1994 work, Pathologies of Rational Choice Theory, Green and Shapiro argue that the empirical outputs of rational choice theory have been limited. They contend that much of the applicable literature, at least in political science, was done with weak statistical methods and that when corrected many of the empirical outcomes no longer hold. When taken in this perspective, rational choice theory has provided very little to the overall understanding of political interaction - and is an amount certainly disproportionately weak relative to its appearance in the literature. Yet, they concede that cutting edge research, by scholars well-versed in the general scholarship of their fields (such as work on the U.S. Congress by Keith Krehbiel, Gary Cox, and Mat McCubbins) has generated valuable scientific progress.

Duncan Foley (2003, p. 1) has also provided an important critic of the concept of Rationality and its role in Economics. He argued that

“Rationality” has played a central role in shaping and establishing the hegemony of contemporary mainstream economics. As the specific claims of robust neoclassicism fade into the history of economic thought, an orientation toward situating explanations of economic phenomena in relation to rationality has increasingly become the touchstone by which mainstream economists identify themselves and recognize each other. This is not so much a question of adherence to any particular conception of rationality, but of taking rationality of individual behavior as the unquestioned starting point of economic analysis.

Foley (2003, p. 9) went on to argue that

The concept of rationality, to use Hegelian language, represents the relations of modern capitalist society one-sidedly. The burden of rational-actor theory is the assertion that “naturally” constituted individuals facing existential conflicts over scarce resources would rationally impose on themselves the institutional structures of modern capitalist society, or something approximating them. But this way of looking at matters systematically neglects the ways in which modern capitalist society and its social relations in fact constitute the “rational”, calculating individual. The well-known limitations of rational-actor theory, its static quality, its logical antinomies, its vulnerability to arguments of infinite regress, its failure to develop a progressive concrete research program, can all be traced to this starting-point.

Schram and Caterino (2006) contains a fundamental methodological criticism of rational choice theory for promoting the view that the natural science model is the only appropriate methodology in social science and that political science should follow this model, with its emphasis on quantification and mathematization. Schram and Caterino argue instead for methodological pluralism. The same argument is made by William E. Connolly, who in his work Neuropolitics shows that advances in neuroscience further illuminate some of the problematic practices of rational choice theory.

More recently Edward J. Nell and Karim Errouaki (2011, Ch. 1) argued that:

The DNA of neo-Classical economics is defective. Neither the Inductive Problem, nor the problems of Methodological Individualism can be solved within the framework of neoclassical assumptions. The neo-Classical approach is to call on Rational Economic Man to solve both. Economic relationships that reflect Rational choice should be ‘projectible’. But that attributes a deductive power to ‘rational’ that it cannot have consistently with Positivist (or even Pragmatist) assumptions (which require deductions to be simply analytic). To make rational calculations projectible, the agents may be assumed to have idealized abilities, especially foresight; but then the Inductive Problem is out of reach because the agents of the world do not resemble those of the model. The agents of the model can be abstract, but they cannot be endowed with powers actual agents could not have. This also undermines Methodological Individualism; if behaviour cannot be reliably predicted on the basis of the ‘rational choices of agents’ a social order cannot reliably follow from the choices of agents.

Furthermore, Pierre Bourdieu fiercely opposed rational choice theory as grounded in a misunderstanding of how social agents operate. Bourdieu argued that social agents do not continuously calculate according to explicit rational and economic criteria. According to Bourdieu, social agents operate according to an implicit practical logic—a practical sense—and bodily dispositions. Social agents act according to their "feel for the game" (the "feel" being, roughly, habitus, and the "game" being the field).

An evolutionary psychology perspective is that many of the seeming contradictions and biases regarding rational choice can be explained as being rational in the context of maximizing biological fitness in the ancestral environment but not necessarily in the current one. Thus, when living at subsistence level where a reduction of resources may have meant death it may have been rational to place a greater value on losses than on gains. It may also explain differences between groups such as males being less risk-averse than females since males have more variable reproductive success than females. While unsuccessful risk-seeking may limit reproductive success for both sexes, males may potentially increase their reproductive success much more than females from successful risk-seeking.

Benefits

Describing the decisions made by individuals as rational and utility maximizing may seem to be a tautological explanation of their behavior that provides very little new information. While there may be many reasons for a rational choice theory approach, two are important for the social sciences. First, assuming humans make decisions in a rational, rather than a stochastic manner implies that their behavior can be modeled and thus predictions can be made about future actions. Second, the mathematical formality of rational choice theory models allows social scientists to derive results from their models that may have otherwise not been seen, and submit these theoretical results for empirical verification. Despite these benefits, there is nothing about rational choice theory that tells scholars that they should reject other methods of investigating questions about the economy and society, such as the sociological determination of individual tastes.

See also

• Bounded rationality
• Decision theory
• Homo economicus
• Game theory
• Neoclassical economics
• Positive political theory
• Rational expectations
• Rationality
• Social choice theory
• Collective Intentionality
• Parrando's Paradox

References

• Abella, Alex (2008). Soldiers of Reason: The RAND Corporation and the Rise of the American Empire. New York: Harcourt.
• Allingham, Michael (2002). Choice Theory: A Very Short Introduction, Oxford.
• Amadae, S.M.(2003). Rationalizing Capitalist Democracy: The Cold War Origins of Rational Choice Liberalism, Chicago:University of Chicago Press.
• Arrow, Kenneth J. ([1987] 1989). "Economic Theory and the Hypothesis of Rationality," in The New Palgrave: Utility and Probability, pp. 25-39.
• Bicchieri, Cristina (1993). Rationality and Coordination. Cambridge University Press
• Bicchieri, Cristina (2003). “Rationality and Game Theory”, in The Handbook of Rationality, The Oxford Reference Library of Philosophy, Oxford University Press.
• Downs, Anthony (1957). "An Economic Theory of Democracy." Harper.
• Coleman, James S. (1990). Foundations of Social Theory
• Dixon, Huw (2001), Surfing Economics, Pearson. Especially chapters 7 and 8
• Elster, Jon (1979). Ulysses and the Sirens, Cambridge University Press.
• Elster, Jon (1989). Nuts and Bolts for the Social Sciences, Cambridge University Press.
• Elster, Jon (2007). Explaining Social Behavior - more Nuts and Bolts for the Social Sciences, Cambridge University Press.
• Fernandez-Huerga (2008.) The Economic Behavior of Human Beings: The Institutionalist//Post-Keynesian Model" Journal of Economic Issues. vol. 42 no. 3, September.
• Schram, Sanford F. and Brian Caterino, eds. (2006). Making Political Science Matter: Debating Knowledge, Research, and Method. New York and London: New York University Press.
• Walsh, Vivian (1996). Rationality, Allocation, and Reproduction, Oxford. Description and scroll to chapter-preview links.
• Martin Hollis and Edward J. Nell (1975) Rational Economic Man. Cambridge: Cambridge University Press.
• Foley D. K (1989) Ideology and Methodology. An unpublished lecture to Berkeley graduate students in 1989 discussing personal and collective survival strategies for non-mainstream economists.
• Foley, D.K (1998). Introduction (chapter 1) in Peter S. Albin, Barriers and Bounds to Rationality: Essays on Economic Complexity and Dynamics in Interactive Systems. Princeton: Princeton University Press.
• Foley, D. K (2003) Rationality and Ideology in Economics. lecture in the World Political Economy course at the Graduate Faculty of New School UM, New School.
• Boland, L. (1982) The Foundations of Economic Method.London: George Allan & Unwin
• Edward J. Nell and Errouaki, K. (2011) Rational Econometric Man. Cheltenham: E.Elgar.
• Pierre Bourdieu (2005) The Social Structures of the Economy, Polity 2005
• Calhoun, C. et al. (1992) "Pierre Bourdieu: Critical Perspectives." University of Chicago Press.
• Grenfell, M (2011) "Bourdieu, Language and Linguistics" London, Continuum.
• Grenfell, M. (ed) (2008) "Pierre Bourdieu: Key concepts" London, Acumen Press

Notes

^ • At JEL:C7 of the Journal of Economic Literature classification codes.

   • R.J. Aumann (2008). "game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
   • Martin Shubik (1981). "Game Theory Models and Methods in Political Economy," in Kenneth Arrow and Michael Intriligator, ed., Handbook of Mathematical Economics, v. 1, pp. 285–330 doi:10.1016/S1573-4382(81)01011-4.
   • Carl Shapiro (1989). "The Theory of Business Strategy," RAND Journal of Economics, 20(1), pp. 125–137 JSTOR 2555656.

External links

• Rational Choice Theory at the Stanford Encyclopedia of Philosophy
• Rational Choice Theory - Article by John Scott
• The New Nostradamus - on the use by Bruce Bueno de Mesquita of rational choice theory in political forecasting
• To See The Future, Use The Logic Of Self-Interest - NPR audio clip

Category:Economic methodology Category:Underlying principles of microeconomic behavior Category:Economic theories