The Invisible Hand in Decision Making

RATIONAL ECONOMIC BEHAVIOUR AND ITS LIMITATIONS

Written by: Srisamvruta Sridhar and Aditya Bhatia

Edited by- Dhruv Mathur, Ivannah Jacob and Tanuj Waghray

Every time someone makes a choice, an “invisible hand” guides them towards choosing what best fits their own self interest. This was the metaphor used in 1776 by Economist Adam Smith to lay the foundation of the rational choice theory to illustrate hidden forces influencing economic behaviour in the free market.

Rational choice theory is an economic framework which proposes that individuals analyse pros and cons while making decisions, and prioritise their own welfare by maximising benefits and minimising costs. Furthermore, these decisions are best taken by the individual themselves, rather than any outside party acting on their behalf. Simply put, people always try to do what’s best for themselves.

According to the theory, individuals driven by self-interest and rationality will take decisions leading to the benefit of the whole economy. The incessant interactions between individual pressures on market demand and supply causes the natural movement of prices and the flow of trade. Thus, economists supporting this theory believe that economic prosperity can be maximised by lessening government intervention and exploiting free-market exchange opportunities.

The theory is used in several fields to predict market outcomes and consumer behaviour because of how it simplifies complex human behaviour. For example, in the business sector, consumer purchasing is forecasted using the theory and in addiction management, it is used to explain the inherent motivations for the consumption of a substance. Moreover, the theory is also used to examine and predict voting patterns in the political sector, thus evidencing the versatility and utility of this theory.

However, despite its seeming popularity as a model for economic use, the concept of rational economic behaviour is studied primarily as a theoretical concept because of the limitations it presents. Behavioural economists note that in the real world, consumers never exhibit fully rational behaviour. While the pillars of decision making relate to extrinsic ideas like scarcity, opportunity cost and value, decisions are also highly influenced by intrinsic, non-standardised concepts: emotions, biases, personalities and risk aversions. This means the basis of and benefit from a decision varies from person to person, even if the decision being made is exactly the same.

The concept of bounded rationality demonstrates that due to imperfect availability of market information, humans are incapable of considering all possible decisions. This means utility maximisation is not possible and people instead satisfice or seek to make a decision that is acceptable for them. Additionally, people may not always act in self-interest , hence in some cases they seek to make decisions that benefit others. An example of this is reciprocity where individuals exchange things for mutual benefit. In such cases, the intangible satisfaction of helping someone else replaces the utility from consumption.

For example, according to the model, a subsidy being given to agricultural products is rational for the government as it would increase food security and overall population health. However, it can distort market prices and encourage wastage of resources, impacts which are not considered by the model. The oversimplification of real-world concepts leads to such unexpected outcomes and market inefficiencies.

In conclusion, rational economic behaviour is a model that makes it simple to generalise consumer responses to changing situations, like price hikes or decreased taxation. It provides valuable insights into the functioning of markets and economic systems. However, it is important to acknowledge that human decision-making is not always perfectly rational, and emotions, biases, and other factors can influence choices in complex ways, making the real world more nuanced than this simplified model suggests.

Bibliography

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2. Ganti, A. (2011, February 14). Rational choice theory: What it is in economics, with examples. Investopedia. https://www.investopedia.com/terms/r/rational-choice-theory.asp

3. Hayes, Adam. “Understanding Rational Behavior.” Investopedia, 2019, www.investopedia.com/terms/r/rational-behavior.asp.

4. Tejvan Pettinger. “Rational Economic Man – Homo Economicus - Economics Help.” Economicshelp.org, 22 June 2017, www.economicshelp.org/blog/27358/concepts/rational-economic-man-homo-economicus/.

“Rational Behavior.” Corporate Finance Institute, corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/rational-behavior/.