Paradox of Rationality

AAA

DEFINITION of 'Paradox of Rationality'

The irony that rational decision-making in game theory situations often has poorer payoffs or outcomes than choices made illogically or naively. The paradox of rationality underscores the contradiction between intuition and reasoning according to game theory. This paradox arises because the rational outcomes predicted by backward induction, the main form of game theory analysis, diverge widely from intuitive choices. The paradox of rationality is consistently observed in experimental studies of game theory using such well-known games as prisoner’s dilemma and the centipede game.

INVESTOPEDIA EXPLAINS 'Paradox of Rationality'

The paradox of rationality is highlighted by a popular game theory scenario known as the Traveler’s Dilemma, devised by economist Kaushik Basu in 1994. Traveler’s Dilemma presents a scenario in which an airline damages identical antiques purchased by two independent travelers.

When pressed for compensation by the travelers for the damage, the airline manager – who has no clue about the value of the damaged goods – comes up with a novel solution to the problem of estimating the antiques’ value. He tells the two travelers to separately write down the value as any number between $2 and $100. If both write down the same number, the inference is that they are telling the truth and the airline will reimburse them that amount. But if they write different numbers, the manager will assume that the lower number is the actual value and that the higher value is inaccurate. The airline will therefore pay both travelers the lower figure, with a bonus of $2 for the traveler who wrote the lower number and a penalty of $2 for the traveler with the higher number. Thus, if A writes $50 and B write $55, A receives $52 ($50 + $2 bonus) as compensation, while B gets $48 ($50 - $2 penalty).

According to backward induction, the rational choice in terms of the Nash equilibrium is $2. However, in experimental studies, most people pick $100 or a number close to it. This includes people who have made a naïve selection without thinking the problem through, as well as those who are aware that they are deviating from the rational choice. The fact that substantially higher payoffs are possible by rejecting the rational choice and acting illogically or naively is the paradox of rationality.

RELATED TERMS
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s ...
  2. Centipede Game

    An extensive-form game in game theory in which two players alternately ...
  3. Decision Analysis - DA

    A systematic, quantitative and visual approach to addressing ...
  4. Decision Theory

    An interdisciplinary approach to determine how decisions are ...
  5. Decision Tree

    A schematic tree-shaped diagram used to determine a course of ...
  6. Game Changer

    1. A person who is a visionary. 2. A company that alters its ...
RELATED FAQS
  1. Why is Game Theory useful in business?

    Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy ... Read Full Answer >>
  2. What is the variance/covariance matrix or parametric method in Value at Risk (VaR)?

    The parametric method, also known as the variance-covariance method, is a risk management technique for calculating the value ... Read Full Answer >>
  3. What is backtesting in Value at Risk (VaR)?

    The value at risk is a statistical risk management technique that monitors and quantifies the risk level associated with ... Read Full Answer >>
  4. How do I discount Free Cash Flow to the Firm (FCFF)?

    Discounted free cash flow for the firm (FCFF) should be equal to all of the cash inflows and outflows, adjusted to present ... Read Full Answer >>
  5. What is RiskMetrics in Value at Risk (VaR)?

    RiskMetrics is a methodology that contains techniques and data sets used to calculate the value at risk (VaR) of a portfolio ... Read Full Answer >>
  6. What are some of the advantages and disadvantages of DuPont Analysis?

    DuPont analysis is a potentially helpful tool for analysis that investors can use to make more informed choices regarding ... Read Full Answer >>
Related Articles
  1. Retirement

    Rolling Over Company Stock: A Decision To Think Twice About

    It may be more beneficial for you to pay tax now than deferring it to an IRA. We show you how and why.
  2. Economics

    Advanced Game Theory Strategies For Decision-Making

    The importance of game theory to modern analysis and decision-making can be gauged by the fact that since 1970, as many as 12 leading economists and scientists have been awarded the Nobel Prize ...
  3. Economics

    Utilizing Prisoner’s Dilemma In Business And The Economy

    The Prisoner’s Dilemma, one of the most famous game theories, provides a framework for understanding how to strike a balance between cooperation and competition, and is a very useful tool for ...
  4. Investing Basics

    Can Games Make You A Better Investor?

    As investing is a great example of an activity that draws on a wide range of mental and emotional skills, it is worth exploring how to improve this skill set.
  5. Active Trading

    How To Survive The Trading Game

    Gain insight into how a trader/programmer approaches the task of designing a trading system.
  6. Options & Futures

    Using Decision Trees In Finance

    These decision-making tools play an integral role in corporate finance and economic forecasting.
  7. Active Trading Fundamentals

    Do Financial Decisions Get Better With Age?

    Like a fine wine, you no doubt get better as you get older, but your money choices might not.
  8. Options & Futures

    Game Theory: Beyond The Basics

    Take your game theory knowledge to the next level by learning about simultaneous games and the Nash Equilibrium.
  9. Fundamental Analysis

    The Basics Of Game Theory

    Break down and examine the potential consequences of economic/financial scenarios.
  10. Economics

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.

You May Also Like

Hot Definitions
  1. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage opportunities in interest rate securities. When using a fixed-income ...
  2. Venture-Capital-Backed IPO

    The selling to the public of shares in a company that has previously been funded primarily by private investors. The alternative ...
  3. Merger Arbitrage

    A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless ...
  4. Market Failure

    An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers ...
  5. Unsystematic Risk

    Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through ...
  6. Security Market Line - SML

    A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky ...
Trading Center