Rational Behavior

What Is Rational Behavior?

Rational behavior refers to a decision-making process that is based on making choices that result in the optimal level of benefit or utility for an individual. The assumption of rational behavior implies that people would rather take actions that benefit them versus actions that are neutral or harm them. Most classical economic theories are based on the assumption that all individuals taking part in an activity are behaving rationally.

Understanding Rational Behavior

Rational behavior is the cornerstone of rational choice theory, a theory of economics that assumes that individuals always make decisions that provide them with the highest amount of personal utility. These decisions provide people with the greatest benefit or satisfaction given the choices available. Rational behavior may not involve receiving the most monetary or material benefit, because the satisfaction received could be purely emotional or non-monetary.

For example, while it is likely more financially beneficial for an executive to stay on at a company rather than retire early, it is still considered rational behavior for her to seek an early retirement if she feels the benefits of retired life outweigh the utility from the paycheck she receives. The optimal benefit for an individual may involve non-monetary returns.

Further, a person’s willingness to take on risk, or conversely, their aversion to risk, may be considered rational depending on their goals and circumstances. For example, an investor may choose to take on more risk in his own retirement account than in an account designated for his children's college education. Both would be considered rational choices for this investor.

Behavioral Economics

Behavioral economics is a method of economic analysis that considers psychological insights to explain human behavior as it relates to economic decision-making. According to rational choice theory, the rational person has self-control and is unmoved by emotional factors. However, behavioral economics acknowledges that people are emotional and easily distracted, and therefore, their behavior does not always follow the predictions of economic models. Psychological factors and emotions influence the actions of individuals and can lead them to make decisions that may not appear to be entirely rational.

Behavioral economics seeks to explain why people make certain decisions about how much to pay for a cup of coffee, whether or not to pursue a college education or a healthy lifestyle, and how much to save for retirement, among other decisions that most people have to make at some point in their life.

Investors may also make decisions primarily based on emotions, for example, investing in a company for which the investor has positive feelings, even if financial models suggest the investment is not wise.

Example of Rational Behavior

For example, an individual may choose to invest in the stock of an organic produce operation, rather than a conventional produce operation, if they have strong beliefs in the value of organic produce. They may choose to do this regardless of the present value of the organic operation compared with that of the conventional operation, and despite the fact that the conventional operation would earn a higher return.