Traveler's Dilemma

AAA

DEFINITION of 'Traveler's Dilemma'

A non-zero-sum game played by two participants in which both players attempt to maximize their own payoff without regard for the other. "Traveler’s dilemma," devised by economist Kaushik Basu in 1994, presents a scenario in which an airline severely damages identical antiques purchased by two different travelers. The airline manager is willing to compensate them for the loss of the antiques, but as he has no idea about their value, he tells the two travelers to separately write down their estimate of the value as any number between $2 and $100 without conferring with one another. However, there are a couple of caveats:

  • If both travelers write down the same number, he will reimburse each of them that amount.
  • If they write different numbers, the manager will assume that the lower price is the actual value and that the person with the higher number is cheating. While he will pay both of them the lower figure, the person with the lower number will get a $2 bonus for honesty, while the one who wrote the higher number will get a $2 penalty.

What strategy should they follow to determine the number to write down?

INVESTOPEDIA EXPLAINS 'Traveler's Dilemma'

The rational choice for the number to write down, in terms of the Nash equilibrium, is $2. However, most people pick $100 or a number close to it, which includes people who have not done the requisite deductive reasoning and have made a “naive” selection, as well as those who are fully aware that they are deviating from the rational choice.

How can $2, the minimum compensation level, be the rational choice or the Nash equilibrium? The reasoning goes as follows. Traveler A’s first impulse may be to write down $100; if Traveler B also writes down $100, that is the amount she will receive from the airline manager. But upon second thought, Traveler A reasons that if he writes $99, and B puts down $100, then A would receive $101 ($99 + $2 bonus). But A believes that this line of thinking will also occur to B, and if she also puts down $99, both would receive $99. So A would really be better off putting down $98, because then she would get $100 ($98 +$2 bonus) if B writes $99. But since this same thought of writing $98 could occur to B, A considers putting down $97 (because then she would get $99 if B writes $98), and so on. This line of deductive logic will take the travelers all the way down to the smallest permissible number, which is $2.

This style of analysis, which is called backward induction in game theory, predicts that each player will write $2. This is $98 less than what each traveler would have earned if they had naively gone for the highest number without thinking the problem through. If they both write down $2, then they each get $2 as reimbursement.

According to Basu, herein lies the problem. While most people intuitively feel that they would select a much higher number than $2, this intuition seems to contradict the logical outcome predicted by game theory (that each traveler would select $2). By rejecting the logical choice and acting illogically by writing a higher number, people end up getting a substantially bigger payoff. Basu calls this the “paradox of rationality” that bedevils game theory.

Traveler’s dilemma can be applied to analyze real-life situations, such as how an arms race between two countries incrementally progresses to worsening outcomes.

RELATED TERMS
  1. Principal-Agent Problem

    Conflicts of interest and moral hazard issues that arise when ...
  2. Decision Theory

    An interdisciplinary approach to determine how decisions are ...
  3. Contract Theory

    The study of how individuals and businesses construct and develop ...
  4. Mechanism Design Theory

    An economic theory that seeks to determine the situations in ...
  5. Tit For Tat

    A game-theory mechanism which is subject to a payoff matrix similar ...
  6. Diner's Dilemma

    A game-theory situation with several players. Similar to a prisoner's ...
Related Articles
  1. Economics

    Economics Basics

    Learn economics principles such as the relationship of supply and demand, elasticity, utility, and more!
  2. Economics

    Macroeconomics

    Find out everything you need to know about macroeconomics.
  3. Investing Basics

    Avoid These Common Investing Psychology Traps

    There are a number of very common psychological traps or errors that investors typically make. You can save a lot of money and misery by avoiding them.
  4. Adam Smith is considered the founder of modern economics.
    Economics

    Adam Smith: The Father Of Economics

    This free thinker promoted free trade at a time when governments controlled most commercial interests.
  5. Economics

    The Uncertainty Of Economics: Exploring The Dismal Science

    Learning about the study of economics can help you understand why you face contradictions in the market.
  6. Fundamental Analysis

    The Difference Between Finance And Economics

    Learn the differences between these closely related disciplines and how they inform and influence each other.
  7. Options & Futures

    Why is Game Theory useful in business?

    Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy and an extensive mix of other academic areas. Eight Noble Prizes ...
  8. Personal Finance

    Microeconomics

    This tutorial teaches the basics of one of the most important economic topics. A must for all investors.
  9. 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.
  10. Fundamental Analysis

    The Basics Of Game Theory

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

You May Also Like

Hot Definitions
  1. Christmas Island Dollar

    The former currency of Christmas Island, an Australian island in the Indian Ocean that was discovered on December 25, 1643. ...
  2. Santa Claus Rally

    A surge in the price of stocks that often occurs in the week between Christmas and New Year's Day. There are numerous explanations ...
  3. Commodity

    1. A basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often ...
  4. Deferred Revenue

    Advance payments or unearned revenue, recorded on the recipient's balance sheet as a liability, until the services have been ...
  5. Multinational Corporation - MNC

    A corporation that has its facilities and other assets in at least one country other than its home country. Such companies ...
  6. SWOT Analysis

    A tool that identifies the strengths, weaknesses, opportunities and threats of an organization. Specifically, SWOT is a basic, ...
Trading Center