Rational Decision Making

Rational Decision Making

Much of economic theory is based on the assumption that people’s economic choices are rational. This means two things:

  1. They always try to maximise their own economic self-interest
  2. They are able to assess the economic costs and benefits to themselves of making alternative choices

We can apply this idea of rational behaviour to the following economic agents:

Consumers

Economists have tended to assume that we spend our money (and time) to achieve the maximum possible satisfaction of our wants from our limited resources (income). This satisfaction, which is private, subjective and unique to each individual cannot be directly measured, is called utility. The assumption can explain, for instance, why consumers buy more of a good when its price falls, as they are able to increase their utility by switching some of their spending to the cheaper good.

Rational Decision Making, figure 1

Firms

Economists have assumed that firms seek to maximise their profits, and this is the only goal they have. The assumption can be used to explain why a firm might replace workers with machines if wages rise, for instance.

Workers

They are assumed to work only to maximise their economic reward; wages, bonuses and other payments together with factors such as job security, pensions and the impact of the job on their health.

The assumption of rational behaviour in all circumstances is questionable, to say the least. More recent economic theory has looked at the wider influences on people’s economic choices. Consumers may, for instance be prepared to pay higher prices for ‘fair trade’ goods. Owners of businesses may be concerned with power and status, not just profit. For example most Premiership football clubs make a loss, but there is no shortage of wealthy business people who want to own them.

Marginal Analysis

Many economic decisions are concerned with relatively small adjustments to our behaviour in the light of changing circumstances. For instance, if the price of petrol goes up, we are unlikely to give up using our car completely, but we may make fewer journeys or go a bit slower to conserve fuel. This is a marginal change. All the time we are comparing the marginal benefit with the marginal cost of economic decisions.