Rational Choice Theory & Homo Economicus

Table of Contents

Rational Choice Theory

Homo Economicus

Critiques

Rational Choice Theory

The “Homo Economicus” theory of human behavior makes predictions about both how individuals will make choices under risk and how individuals will behave in strategic interactions (defined below). This theory of human behavior is based on the axioms of a more general theory of human behavior called rational choice theory.

Rational choice theory, in essence, imposes a set of restrictions on how an individual makes a choice among a set of alternatives. It says, “If your individual preferences, which lead you to make a particular choice, satisfy the following criteria, then that choice is a rational one.”

Rational choice theory begins with the assumption that people have fixed and stable preferences over alternatives (Levin & Milgrom, 2004). That is, if a person is faced with a choice between an apple and an orange, and prefers an apple today, then he must also prefer the apple to the orange tomorrow. 

Rational choice theory goes on to impose two conditions on individuals’ preferences amongst alternatives. The first condition is that individuals’ preferences must be complete (Levin & Milgrom, 2004). An individual’s preferences amongst a set of alternatives X are complete if for any pair of choices xi,xj ∈ X, he considers xi to be at least as good as xj, or he considers xj to be at least as good as xi, or both. In other words, an individual’s preferences amongst a set of alternatives are complete if he has a preference amongst any two alternatives with which he is faced. He is allowed to be indifferent between the two alternatives, but he must always be able to state a preference. So, for example, if faced with a choice between apples and bananas, the individual must be able to say that he considers apples to be at least as good bananas or he considers bananas to be at least as good apples or he considers both of them to be at least as good as each other. But he may not say that he does not know which he prefers. 

Rational choice theory also requires an individual’s preferences to be transitive (Levin & Milgrom, 2004). An individual’s preferences among a set of alternatives X are transitive if, whenever he considers xi to be at least as good as xj and he considers xj to be at least as good as xz, then he considers xi to be at least as good as xz. For example, if he considers apples to be at least as good bananas and bananas to be at least as good oranges, then rational choice theory requires that he must consider apples to be at least as good oranges. This condition implies that preferences cannot cycle. That is, an individual cannot prefer apples to bananas, and bananas to oranges, and oranges to apples. 

Building on the assumptions that individuals’ preferences are stable, complete, and transitive, rational choice theory states that given a set of alternatives, a decision-maker will choose the alternative that is at least as good as all the other alternatives available (Levin & Milgrom, 2004). That is, given that an individual is capable of stating his preference amongst alternatives, that his preferences do not cycle, and that his preferences do not change over time, it must be the case that, when faced with a set of alternatives, an individual will choose the one he most prefers. For example, if I am able to state my preference for apples over bananas, and bananas over oranges (i.e. completeness), and apples over oranges (i.e. transitivity), and these preferences never change (i.e. stable preferences), then it must be the case that when I’m faced with a choice between apples, bananas, and oranges, I will always choose apples.

Rational choice theory assigns a numerical ranking to each possible choice (Levin & Milgrom, 2004). This numerical ranking represents the “utility” an individual derives from making a particular choice (Levin & Milgrom, 2004). That is, the numerical ranking represents the benefit one receives from making a particular choice. Once utilities are assigned to the various choices, picking the preferred choice simply amounts to picking the choice with the highest utility (Levin & Milgrom, 2004).

Homo Economicus

A large intellectual edifice has been built upon the foundation of rational choice theory. Economics draws heavily on rational choice theory. Moreover, game theory is built on a rational choice theory foundation. And, game theory itself is used as a tool in economic analysis. This reliance of economics upon rational choice theory foundations has led to a theory of human behavior that is pejoratively called “Homo Economicus,” or “economic man.”

In going about his daily life, the Homo Economicus is faced with a variety of circumstances in which he has to make a decision under risk. According to the rational choice theory-based economic literature, the Homo Economicus uses a tool called expected utility maximization in order to decide how to make choices under risk. Another situation that Homo Economicus often faces which affects his economic well-being is what are called strategic interactions. According to the rational choice theory-based economic literature (drawing on ideas from game theory) the Homo Economicus will perform the same utility maximization procedure as when he is facing a decision under risk. Moreover, according to this literature, because every individual will behave in this way during strategic interactions, the outcomes of strategic interactions are predictable and result in what are called Nash equilibria. Let’s address each of choice under risk and decision-making during strategic interaction in turn.

In going about their daily lives, individuals often face a situation in which they have to choose amongst a set of alternate gambles (i.e. prospects) under risk. How do individuals choose among these prospects? According to the Homo Economicus model, individuals will compute the expected utility of each alternative by performing the following computation:

EU(A)=∑𝑜∈𝑂𝑃𝐴 (𝑜)𝑈(o)

where O is the set of outcomes

PA(o) is the probability of outcome o 

U(o) is the utility of outcome o

A is an alternative (a possible choice)

The Homo Economicus will then choose the alternative with the highest expected utility. That is, when faced with a choice under risk, the Homo Economicus will maximize his expected utility.

Another situation Homo Economicus often faces which affects his economic well-being is what are called strategic interactions. Strategic interactions are situations in which two economic actors are each faced with having to make a choice amongst alternative actions and the payoff to each actor depends not only on the action chosen by that actor, but also on the action chosen by the other economic actor. An example of a strategic interaction would be negotiations between two firms who are trying to agree on the terms of a contract. In this case, the payoff to both firms will depend both on how they bargain in the negotiation and on how the other firm bargains. How do individuals decide which action to take when they are engaged in a strategic interaction? According to the Homo Economicus model of human behavior, the results of such strategic interactions will be what are called Nash equilibria. A Nash equilibrium is the action profile at which no player can make himself better off by unilaterally choosing a different action (Osborne, 2004). In simple terms, each player chooses his action according the model of rational choice, given his belief about what action the other player will take (Osborne, 2004).

In recent years, the emergence of behavioral economics has presented a challenge to rational choice theory and the Homo Economicus model. Learn more about behavioral economics here.

Critiques

Written By: Aiden Singh Published: March 20, 2020

Sources

Levin, Jonathan & Milgrom, Paul. Introduction to Choice Theory. September 2004. 

Osbourne, Martin. An Introduction to Game Theory. Oxford University Press. August 2003