Rational Choice Theory
Categories: Financial Theory
Rational choice theory is the idea in social sciences that people make decisions using rational thought. They use all the info they have, then look at the options they have, as well as their own preferences.
“Rational” not in the colloquial sense, but in the economic and sociological sense. Rational means evaluating options to reach a goal based on preferences. Basically, when someone’s being...calculating. Actions based on a whim that are random or impulsive aren’t rational, since they weren’t thought out with a goal in mind.
Besides economics and sociology, rational choice theory spans across political science and philosophy. This is partially thanks to Gary Becker, an economist who applied rational choice theory in new ways (at the time). For instance, it was previously accepted that criminals were irrational; why would you do x, y, or z when you could get in trouble? Same with drug use: why would you do that when you know it’s not good for you? These choices seemed irrational.
Gary Becker showed us how they are perfectly rational. Criminals weigh the probability of getting caught, the potential reward...all the costs and benefits that go into deciding whether or not to commit a crime. Calculating. Becker once parked illegally, using that to explain how he chose to do it because he was late, and he believed the risk of getting caught was low.
Likewise, addictive drug users. For people who are addicted to drugs, Becker argued it was perfectly rational for them to continue using drugs. Since withdrawal suckkkkssss, it was always more rational to continue using the drugs, as long as the cost of acquiring them was lower than the cost of facing withdrawal symptoms. For people who aren’t using drugs, it's irrational to start using them, since the risk of addiction is high.
Of course, this kind of talk angered nuclear family parents. How could that Nobel Prize-winning economist be telling me that my addicted children are being rational by staying on drugs? Ooof. The colloquial “rational” isn’t the same thing. Regardless, this widened the use of rational choice theory as a way to explain human behavior.
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Econ: What are Rational Expectations?5 Views
And finance Allah shmoop what are rational expectations Alright people
Well life can change pretty quickly One day you're the
CEO of a Wall Street hedge fund making a fifteen
twenty thirty million dollars a year or more than one
bad experience with a cursive monkey paw and poof You're
the break dance guy on the subway busking for ninety
bucks a day in tips Yeah I guess you shouldn't
have wished to become a better dancer Well but given
that you can never tell exactly what will happen in
the future how do you decide what to do Day
today Lt'll economists have a model they use It's called
rational expectations The theory assumes that people make economic decisions
based on their reasonable assumptions about what's gonna happen in
the future Folks look at their current situation and it
what's happened in the past and from there they make
educated guesses about what's likely to happen in the future
Well these expectations in turn become the bases or foundation
for their decision making Gas prices have been low forest
long as you can remember so you don't care much
about fuel efficiency when you go out and buy a
car So you go for the ten miles a gallon
Hummer Rational expectation Until militants take over Saudi Arabia's largest
oil production field gas prices spike Now you're paying two
hundred dollars a month to fill your gas tank Remember
a lot of economic activity is based on what people
think will happen in the future Will people borrow money
planning to pay it back years In the future they
buy houses with thirty year mortgages They choose college majors
with an eye toward a forty year career Well aside
from philosophy majors maybe people make decisions based on what
they think the future will be like right Robert Lucas
won the Nobel Prize in nineteen ninety five for his
work on the theory of rational expectations This guy well
quick fun fact When Lucas Scott divorce from his wife
Rita in the late nineteen eighties the divorce agreement included
a stipulation that she would get half of his Nobel
Prize winnings if he ever won the award However the
Klaus had an expiration date of Halloween nineteen ninety five
He officially won his prize on October tenth nineteen ninety
five just under the wire So okay most of us
don't rationally expect our spouse is to win half a
Nobel Prize kind of money but most of us are
just happy if they remember to put down the toilet
seat But yeah we do make other long term decisions
based on what we think we'll be able to make
on an ongoing basis in your hedge fund days You
wouldn't think twice about taking on a five million dollar
mortgage for a vacation place in Bermuda However you never
take on that responsibility If you knew that your monkey
paw wish was going to go sideways and you know
leave you with eighteen thousand dollars in annual salary your
rational expectations impact your big long term money making decisions
They also play into your smaller data day decisions Even
deciding what you're going to have for dinner relates to
how much money you expect to make in the near
future Will the precursor version of you while you then
might have gotten the nine course tasting menu It hearsay
with the caviar Black Australian truffles flog raw and wagyu
beef The bill would run six hundred bucks a person
but you can afford it So like who cares The
post curse break dance version of you might decide to
go with the Junior Bacon cheeseburger off Lindy's Value menu
which costs a buck ninety nine Yeah that's all you
can afford But the rational part of rational expectations assumes
that your predictions will stem from past experience Unless you've
had trouble with cursing objects before it's unlikely that you'll
see the bad wish scenario coming Given that you've been
a fifteen million dollars plus a year hedge fund manager
for twenty years at five million dollars vacation home or
good seems very manageable There's no reason to expect your
job to change The reasonable assumption is that you'll keep
your fat salary for the foreseeable future Well dinner's at
per se a vacation spots in Bermuda Yeah but then
you wandered into that dingy curiosity shop on your last
trip to Hong Kong and asked the man behind the
counter if he had anything really interesting Then he started
stroking his beard and well on the bright side you
always wanted to be able to do the worm Yeah 00:03:55.178 --> [endTime] Yeah