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.

Traveler's Dilemma
A nonzerosum game played by two participants in which both ... 
Rationing
The artificial restriction of raw materials, goods or services. ... 
Rational Expectations Theory
An economic idea that the people in the economy make choices ... 
Capital Rationing
The act of placing restrictions on the amount of new investments ... 
Rational Behavior
A decisionmaking process that is based on making choices that ... 
Backward Induction
The process of deducing backwards from the end of a problem or ...

Trading
Understanding Rational Choice Theory
Rational choice theory assumes an individual will always make prudent and logical decisions that yield the most benefits. 
Trading
Explaining Rational Behavior
Rational behavior guides the decisionmaking process toward choices that maximize an individualâ€™s benefit. 
Markets
The Basics Of Game Theory
Break down and examine the potential consequences of economic/financial scenarios. 
Markets
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 ... 
Markets
Prisoner's Dilemma
Learn more about this classic game theory scenario. 
Trading
7 Controversial Investing Theories
We take a closer look at the theories that attempt to explain and influence the market. 
Investing
How To Game The Video Game Industry
Investopedia explores the business, current developments, future trends of video games industry and how the overall industry makes money. 
Investing
How The Video Game Industry Is Changing
Video game creation has become increasingly complex, and the cost of creating a game to run on one of the major consoles has risen with this greater complexity. 
Markets
The Nash Equilibrium
Nash Equilibrium is a key concept of game theory, which helps explain how people and groups approach complex decisions. Named after renowned mathematician John Nash, the idea of Nash Equilibrium ... 
Trading
Modern Portfolio Theory vs. Behavioral Finance
Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions ...

Why is Game Theory useful in business?
Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy ... Read Answer >> 
What emerging markets are best suited for investing in the aerospace sector?
Discover the best emerging markets suited for investing in the aerospace sector and how middle class growth best positions ... Read Answer >> 
What does the Nash equilibrium predict?
Learn more about the famous Nash equilibrium, which is the revolutionary concept in game theory about the economics of human ... Read Answer >> 
How is game theory related to the Nash equilibrium?
Learn how Nash's equilibrium is an important concept in game theory, and understand how it applies to the common prisoner's ... Read Answer >> 
What is "marginalism" in microeconomics and why is it important?
Find out what economists mean by marginal utility or cost and why marginalism is such an important concept in microeconomic ... Read Answer >> 
What is the difference between a dominant strategy solution and a Nash equilibrium ...
Dive into game theory and the Nash equilibrium, and learn why the Nash equilibrium assumptions about information are less ... Read Answer >>