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Wednesday 31 October 2012

Rational Choice Theory and Business Decision Making

Rational Choice Theory and Business Decision Making

The shareholder of a business enterprise gives manager(s) the mandate to make decisions on their behalf.  In any business organization, the management ought to make day to day decisions in order to achieve the predetermined goals/objectives of the business. The manager is expected to have knowledge of the set goals of the business and come up with a strategic plan to achieve them.

The management has to choose how to allocate the scarce resources to the most efficient among the productive processes available.  Therefore, awareness of the business environment and the alternatives course of action enable those with the managerial position to make informed decisions for profit maximization.

Rational choice theory
The choice theory is a model that explains how individuals tend to minimize cost so that they can maximize the returns. Individuals will therefore prefer an action that requires less costly activity but maximizes the profit. The theory does not consider the intrinsic cost issues but just the extrinsic cost of preferring this course of action to another by comparing cost and benefits of each action differently. Therefore, the model is based on cost-benefit analysis as manager chooses the best action depending on their individual preference and inherent constrains facing them.  These choices cause a pattern of behavior to develop within the society.

In this case the optimal activity may not be undertaken due to the scarcity of economic resources; satisfactory actions are taken out of the given set of individual preferences. Rational decision making could therefore mean choosing the course of action among the given individual preferences. It also includes the action one could take and the estimated outcome of the course of action.

Assumptions of the rational choice decision making model
There are various assumptions that this model is based on.

Preference
According to the choice theory, individuals are rational and normally act as maximizing entrepreneurs, wanting to get the most useful products at the lowest cost possible and therefore will impose judgment on the usefulness of a product compared to other similar product in their preference function. For instance, if P represents the preferred products 1…n, then the set of all products can be defined in the following preference function:
P= [p1, p 2, p3,, ……., pn]

In case p1 is a highly attractive and benefiting product than p2, then p1 is preferred to p2. Where p1 brings more benefit than p3 but it sharply minimizes profits then, p3 will be preferred to p1. This is a value judgment equation and in this case p3 will be preferred to p2.

An individual judges the usefulness or benefits of products or actions by comparing them with similar products or actions respectively.  Primarily, the product or action that has the highest returns at minimal cost is chosen.

The preference assumption requires individual to be aware of their preferences in terms of:

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