Paradox of Rationality

What Is the Paradox of Rationality?

The paradox of rationality is the observation, in game theory and experimental economics, that players who make irrational or naive choices often receive better payoffs and that those making the rational choices predicted by backward induction often receive worse outcomes. A paradox of rationality appears to show that there are benefits to irrationality or at least to seemingly irrational behavior. It is common to games that have Nash equilibria, which produce overall outcomes that leave the players worse off than they could have been had they chosen less rational individual strategies. When the players do not reach the expected equilibrium solution it suggests that something more than purely rational individual choice is at work.

Understanding the Paradox of Rationality

The paradox of rationality is consistently observed in experimental studies of game theory using such well-known games as the prisoner’s dilemma, the traveler’s dilemma, the diner’s dilemma, the public good game, and the centipede game — and underscores the contradictions between intuition and reasoning and between the predictions of rational choice theory and actual behavior.

Such seemingly irrational behavior can lead to results that cannot be explained by theories that solely rely on individual rational choice. That people do not always behave rationally is a challenge to traditional economic and financial theories, which assume individual rationality. For example, the theory of public goods, which justifies much of public policy, predicts that individuals will rationally consume as much of any available public good as they can but that none will pay for it or produce it. Yet experiments (and real world experience) show that this is often not the case.

Attempts to explain these results follow two major approaches. Some see them as a challenge to the rationality of individual choice and argue that cognitive biases must be at play in inducing people to choose irrationally. Others modify the individuality of rational choice in a social context and argue that formal and informal social institutions mediate individual choice.

Behavioral Economics

Behavioral economics explicitly considers psychological factors in individual decisions. Various cognitive biases, emotional states, or simple faulty reasoning are the root cause of observed behavior that varies from the game theoretic rational choice. Subjects either lack the rational capacity to arrive at the equilibrium strategy or are guided by unconscious biases that originate from non-rational mental processes, emotions, or habits of behavior. In some cases, new models that adapt traditional game theory logic to reflect these kind of decision maker preferences have been developed.

New Institutional Economics

New institutional economics suggests that social influences on individual economic choice are nearly ubiquitous. With the exception of a castaway on a deserted island, economic decisions routinely occur within the context of multiple layers of collective economic organizations and institutions, including households, families, business firms, clubs, and polities.

The rational choice in a context-free game theoretic setting might be very different from the rational choice that a real individual accustomed to a certain set of formal and informal institutional rules and norms of behavior will make. Consideration of the individual’s specific institutional setting introduces a kind of meta-rationality that is oriented, either by design or by spontaneous order, toward achieving more beneficial outcomes for all members of the group. Experimental subjects inevitably bring this “baggage” with them when they participate in games, and choose strategies that reflect the institutional arrangements that they understand and are conditioned to follow.

Evolutionary Economics

Evolutionary economics bridges the gap between these fields in that it draws on evolutionary biology and evolutionary psychology to explain deviations from individual rational choice. According to evolutionary economics, individuals exhibit the cognitive biases described by behavioral economics and develop the formal and informal frameworks studied by New Institutional economics because of selective evolutionary pressures that produce an adaptive response. Cognitive biases and economic institutions that explain paradoxes of rationality are group evolutionary strategies that can be adapted specifically for overcoming those individually rational game theoretic equilibria that are harmful to the group.