Traveler’s Dilemma and Behavioral Economics

Kaushik Basu has devised an interesting game called Traveler’s Dilemma. The problem is stated as below:

Lucy and Pete, returning from a remote Pacific island, find that the airline has damaged the
identical antiques that each had purchased. An airline manager says that he is happy to
compensate them but is handicapped by being clueless about the value of these strange
objects. Simply asking the travelers for the price is hopeless, he figures, for they will inflate it.
Instead he devises a more complicated scheme. He asks each of them to write down the price
of the antique as any dollar integer between 2 and 100 without conferring together. If both
write the same number, he will take that to be the true price, and he will pay each of them that
amount. But if they write different numbers, he will assume that the lower one is the actual
price and that the person writing the higher number is cheating. In that case, he will pay both
of them the lower number along with a bonus and a penalty–the person who wrote the lower
number will get $2 more as a reward for honesty and the one who wrote the higher number
will get $2 less as a punishment. For instance, if Lucy writes 46 and Pete writes 100, Lucy will
get $48 and Pete will get $44.
What numbers will Lucy and Pete write? What number would you write?

According to the game theory – the payoffs for both Lucy and Pete is – ( 2,2). And this is the Nash equilibrium for the problem at hand. Equilibrium happens at (2,2) if you go by the assumptions of classical economics assumptions – people act rationally and people are selfish and act to maximize their gains irrespective of others. Assume Lucy thinks she can make $100 by telling the price as 100. Soon she realizes she can make $101 by telling the price as 99. Realizing the Pete might play the same trick, she decides she will say 98 etc so on so forth till they reach $2 where the equilibrium happens.

Basu says the – the Nash Equilibrium is reached if the game is played rationally and questions the rationality of players in the real-world.

I agree with him in that people get maximum pay off in this game if they acted irrationally. That is how it works in the real-world!. Often(if not always!), people behave irrationally. That is the question behavioral economics tends to question. It has recognized that there are various cognitive biases that are at play when people make choices. And, most often than not these choices are irrational. If you ask me, if the price of the item in question is $42, then in the real-world you will at least get $42 ( or 40?) or more if people are loss averse. However, by applying the second principle, they can maximize their payoff by quoting a value near 100.

Scott Adams, the creator of Dilbert says that people are irrational. They make choices first and then try to rationalize it by giving various reasons. Even psychologists say humans are irrational. Behavioral economics is trying to explain the economic behavior of people in this light…