Challenges to Rational Choice Theory

The fundemental assumption regarding human behavior, upon which the whole edifice of rational choice theory (RCT) rests is that human beings are rational; specifically, it means that they act in order to maximize their self-interest by “maximizing expected utility”. The construction above takes into account our preferences (utility) and the fact that the link between our actions and outcomes are rarely certain, but that we are able to adequately estimate (beliefs) the likelihood of achieving a specific goal given an accompanying action.

In the example of Lebron James I posted earlier, he has a generally good idea of his preferences (he prefers–other things equal–to hit a 3-pointer over a field goal or a free throw) and his beliefs (he knows his stats regarding his 3-point shooting percentage, his field goal, and free throw percentages as well). Given his beliefs and preferences, Lebron can easily act–and generally does–in an instrumentally rational manner.

How valid, though, is the assumption that human beings do act in an instrumentally rational manner? In other words, do individuals always maximize their expected utility? The short answer is no. Some political scientists believe that political culture often acts to mitigate instrumentally rational behavior. [We’ll discuss this in class on Tuesday.] Whole sub-disciplines in behavioral psychology and behavioral economics can point to copious amounts of research data demonstrating the lack of rationality in human beings, often in fairly simple situations. Michael Sherman asks “why people believe weird [i.e., irrational] things about money”:

Would you rather earn $50,000 a year while other people make $25,000, or would you rather earn $100,000 a year while other people get $250,000? Assume for the moment that prices of goods and services will stay the same.

Surprisingly — stunningly, in fact — research shows that the majority of people select the first option; they would rather make twice as much as others even if that meant earning half as much as they could otherwise have. How irrational is that?

This result is one among thousands of experiments in behavioral economics, neuroeconomics and evolutionary economics conclusively demonstrating that we are every bit as irrational when it comes to money as we are in most other aspects of our lives. In this case, relative social ranking trumps absolute financial status. Here’s a related thought experiment. Would you rather be A or B?

A is waiting in line at a movie theater. When he gets to the ticket window, he is told that as he is the 100,000th customer of the theater, he has just won $100.

B is waiting in line at a different theater. The man in front of him wins $1,000 for being the 1-millionth customer of the theater. Mr. B wins $150.

Amazingly, most people said that they would prefer to be A. In other words, they would rather forgo $50 in order to alleviate the feeling of regret that comes with not winning the thousand bucks. Essentially, they were willing to pay $50 for regret therapy.

Regret falls under a psychological effect known as loss aversion. Research shows that before we risk an investment, we need to feel assured that the potential gain is twice what the possible loss might be because a loss feels twice as bad as a gain feels good. That’s weird and irrational, but it’s the way it is…

…This research goes a long way toward debunking one of the biggest myths in all of psychology and economics, known as Homo economicus.” This is the theory that “economic man” is rational, self-maximizing and efficient in making choices. But why should this be so? Given what we now know about how irrational and emotional people are in all other aspects of life, why would we suddenly become rational and logical when shopping or investing?

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