DEFINITION of 'Paradox of Rationality'
The irony that rational decisionmaking 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 wellknown games as prisoner’s dilemma and the centipede game.
BREAKING DOWN '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.

ZeroSum Game
A situation in which one person’s gain is equivalent to another’s ... 
Centipede Game
An extensiveform game in game theory in which two players alternately ... 
Decision Analysis  DA
A systematic, quantitative and visual approach to addressing ... 
Decision Theory
An interdisciplinary approach to determine how decisions are ... 
Decision Tree
A schematic treeshaped diagram used to determine a course of ... 
Game Changer
1. A person who is a visionary. 2. A company that alters its ...

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. 
Economics
Advanced Game Theory Strategies For DecisionMaking
The importance of game theory to modern analysis and decisionmaking can be gauged by the fact that since 1970, as many as 12 leading economists and scientists have been awarded the Nobel Prize ... 
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 ... 
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. 
Active Trading
How To Survive The Trading Game
Gain insight into how a trader/programmer approaches the task of designing a trading system. 
Options & Futures
Using Decision Trees In Finance
These decisionmaking tools play an integral role in corporate finance and economic forecasting. 
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. 
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. 
Fundamental Analysis
The Basics Of Game Theory
Break down and examine the potential consequences of economic/financial scenarios. 
Fundamental Analysis
Is India the Next Emerging Markets Superstar?
With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.

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 >> 
What is the utility function and how is it calculated?
In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >> 
How can I use a regression to see the correlation between prices and interest rates?
In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >> 
How do I calculate a modified duration using Matlab?
The modified duration gauges the sensitivity of the fixed income securities to changes in interest rates. To calculate the ... Read Full Answer >> 
How do I calculate the rule of 72 using Matlab?
In finance, the rule of 72 is a useful shortcut to assess how long it takes an investment to double given its annual growth ... Read Full Answer >> 
How do I calculate the standard error using Matlab?
In statistics, the standard error is the standard deviation of the sampling statistical measure, usually the sample mean. ... Read Full Answer >>