Should we strive to be rational?

We tend to think of irrationality, like entropy, as something to be struggled against, but whose ultimate eradication, in ourselves and society at large, is impossible. We often see pure rationality as akin to the attainment of wisdom, a yardstick by which we might judge our mistakes and might have beens. In a world of inward thinking, where the struggle is against anonymous natural forces who bear us neither ill will nor good, this is exactly correct. The purely rational decision is indeed the one that best helps us attain our goals, that best helps us to succeed. We teach, and are fascinated by, systematic forms of irrationality--recency bias, false generalizations, loss aversion, sunk cost fallacy, and so on. In class, we often claim that self-knowledge is an essential first step in aiding our avoidance of these pitfalls.

Yet, in the world of outside thinking, none of this is true. In many situations, the attainment of rationality acts as a positive bar toward achieving our objectives. Indeed, even more remarkably, it can act as a bar toward achieving mutually desired outcomes--circumstances where we would all be better off. Irrationality, in these cases is not some genetic baggage handed to us by our hominid ancestors where it was once adaptive and now better off being shed--the cognitive equivalent of the human appendix. Rather, it was and remains a positive adaptation to certain types of social dilemmas.

Let me illustrate this by an example known as the travelers' dilemma. The story goes like this: Two antiques dealers are flying to a convention. Each carries a suitcase containing an identical antique item. Sadly, but perhaps unsurprisingly, their luggage goes missing and cannot be found. The airline is, of course, liable for the amount of the loss up to a maximum of (say) $100. While the airline does not know the precise value of the antiques, it does know that they are worth at least $2. To discover the value, the airline merely asks the antique dealers to write down the value of the lost item, up to the maximum of $100. If their appraisals agree, the airline will pay each the listed amount. If they disagree, the airline will pay each the amount of the lower appraisal. In addition, and this is critical to the story, the airline rewards the "honest" dealer (i.e. the one making the lower appraisal) by paying her a bonus of $2, which is deducted from the compensation paid to the "dishonest" dealer. Thus, if one dealer writes down x and the other y > x. The "x" dealer will receives x + 2 while the "y" dealer will get x - 2. 

Suppose that both dealers know that the true value exceeds the maximum of $100 and both are rational and selfish, caring only about their own reimbursement. Surely, both should simply tell the truth, writing down $100, and be done with it. But the logic of rationality implies something entirely different--in our perfectly rational world, each will write down the lowest value, $2, and receive only this amount in compensation.

The argument is a version of LFRB reasoning. Suppose that dealer 1 expects dealer 2 to tell the truth. Then, by writing down $99 instead of $100, dealer 1 can gain a small advantage to herself, receiving $101 instead of $100. Anticipating this, dealer 2 might instead write down $98, attempting to outfox the clever dealer 1. But, since dealer 1 is purely rational, she is infinitely clever, so she will anticipate this double-cross by 2 and write down $97, and so on until the minimum is reached. Notice what has happened: "society," consisting of the two dealers, might have gained $100 to each of its members. Instead, by pursuing optimal and rational decisions, each member ends up with only $2 instead.

Truth-telling is, of course, an ethical matter. In many cultures, parents strive to "irrationalize" their offspring by proclaiming the virtues of this course of action--especially when there is a temptation to lie for possible gain. Irrationality of this sort is precisely what is needed to improve matters. In this situation, so long as each dealer has enough confidence in the "morality"--or, equivalently, the irrationality--of the other party, offers need not collapse to the minimum. To see this, let us reconsider the calculus of decision making by dealer 1. Her initial conjecture was that dealer 2 would tell the truth, in which case writing down $99 is the best alternative. So long as there is sufficient chance that dealer 2 is moral/irrational and will indeed tell the truth, then $99 is the best course of action. So long as these same beliefs are held by dealer 2, he too will write down $99. While this is not the perfect solution, it massively dominates the world of pure rationality. Notice too that, in the end, both dealers lie (a little) in this scenario. That is, neither has to actually be irrational, sufficient weight on the possibility of moral/irrational actions suffice to break the depressing chain of logic leading to ever lower offers.

The travelers' dilemma is but one of many examples where irrationality is the "solution" to a trust problem. It is, at the very least, somewhat questionable as to whether teaching the tools of pure rationality serves a useful purpose in making us better citizens/leaders/managers. Much depends on whether the situations we face are primarily inward looking or outward looking. My contention, and indeed the whole point of the course, is to suggest that outward looking or, equivalently, social situations dominate the domain of decisions we make.

Class #2 Highlights

The theme of class #2 was look forward, reason back (LFRB), a fundamental idea in game theory. The point of LFRB is to look ahead to the end of the game, anticipate what future moves will be, and then respond accordingly. Anticipation, as we discussed, requires two ingredients:

1. What are the possibilities? What strategies are possible in reaction to my move?
2. What are the preferences? What do the other players value? Do they care about money, reputation, ego, social justice, or something else entirely?

The combination of what is possible and how these possibilities are valued, allows one to anticipate the future (almost like looking into a crystal ball) and react (or pro-act) accordingly.

To get a sense of how this works, we studied two common dilemmas: The trust dilemma and the reputation dilemma. The trust dilemma describes poverty and underinvestment in many places. Here, we considered a situation between an investor and an entrepreneur. The entrepreneur creates a high expected return from the capital investment, but legal institutions are such that contracts cannot be enforced. Faced with a one-off situation, we saw that, no matter how profitable the opportunity, the investor would not commit capital since it would anticipate being expropriated (cheated). Solving this dilemma has preoccupied academics, NGOs, and, of course, banks and other investors, for many years. A common solution is repeated interaction even across generations. The keiretsu system of "family" investment in Asia occurred in large part as a response to this LFRB dilemma. Grameen banks, which use the community sanctions to enforce contracts, represent a more recent response.

Apart from the developing world, versions of this dilemma occur all the time within firms. For instance, one needs help from an expert from another team on a given project. But there is no formal contract for repayment of this service existing within the firm. Depending on the nature of the relationship with the other team or the expert, many times such synergies fail to be realized as the expert, or his team, fear that the project manager will take all the credit for solving the problem without "repaying" the expert.

If you have other examples of the trust dilemma, please share them either in the comment section or by writing me directly.

A more subtle LFRB situation is the reputation dilemma. In this situation, a "long-term" player confronts a succession of n short-term (one-shot) players. The short term player can choose to challenge the long-term player or not and the long-term player must decide whether to fight, which is costly to both, or accommodate. Early in the game, reputation is obviously important, so the long-term player would seem to want to fight (or at least have that reputation). Near the end, however, both players realize that reputation is no longer valuable, so accommodation will be anticipated correctly. Here, we see the power of LFRB--there is no credible way for the long-run player to gain a fighting reputation if she is rational. In effect, the resolve of the player unravels. If the long-run player won't fight the last player, then the penultimate short-run player need not fear either, since there is no reason to fight to maintain a worthless reputation. But now the same is true of the short run player third from the end, and so on...all the way to the beginning.

How can the long-run player solve this situation? Paradoxically, it is her very rationality that is the cause of the problem. If the long-run player were crazy, reputation could easily be maintained, and challenges deterred. The precise way in which this happens is the subject of our next class.

Class #2 Prep

In addition to the assigned readings, you have two key missions for class #2:

1. Find a team to join and decide on a nickname. in advance of class!

2. Read through the NBA free agent game and start planning your strategy as player or incumbent or player. The role of rival firm will be played by my assistant Sibo, in all cases.

Welcome to Game Theory - Fall 2014

Welcome to Game Theory. If you are open to the possibility, this course can fundamentally change the way you look at the world--or at least that is my hope. Why do I think this? The main reason is that game theory fosters what I call "outside thinking" or, if you like, empathy. Game Theory is ultimately about seeing the world through others' eyes--walking a mile in their mocassins--and the adjusting your choices in light of theirs.

Sometimes, situations can be adversarial and the insights gains from empathy are used to frustrate the others' plans, to pre-empt or forestall their best options, or to cause confusion so that they make the wrong choices. When we think of games, such as chess, checkers, backgammon, poker, and so on, we often think of "zero sum" situations where, for one side to win, the other must lose. Empathy in such situations is often called "outsmarting" the other player.

Yet, in many business situations, the "game" may be adversarial, but need not be. Consider two firms competing in price for extremely price sensitive consumers. At first blush, the game seems purely adversarial---for one firm to win the business, the other must lose. And in the short run this is indeed the case. But taking a longer view, one sees possibilities for cooperation. It is in neither firms' interest to enter into a price war, Both desire to avoid such an outcome and are willing to sacrifice some to achieve this, providing the sacrifices are perceived as fair and that they are not too costly compared to pursuing purely selfish ends. Gae Theory is about these situations as well---how can firms bridge their differences and live in harmony.

Apart from empathy, the key learning from the first class was:

Look forward, reason back

This principle underpins much of Game Theory. Roughly, it means that, in making a plan, one needs to look ahead to the likely outcomes, accounting for the reaction of the other players in the game. In chess, it is not enough to simply spot a winning position several moves hence. One also needs to account for the likely reaction of the other player. If she can block the intended advance, generate a more potent threat, or simply capture the piece required for complete the position, then the original plan becomes worthless. Only plans that anticipate reactions are worthwhile.

But how can one anticipate future reactions? The course is Game Theory and not Mind Reading. This is all true, but here we benefit from the fundamental principle of choice imposed by economics:

Individuals will choose whatever action they perceive to be in their best interests.

In a way, this hardly needs to be enunciated as a principle for it seems self-evident. Yet it is important to dispose of some myths about this premise. First, the principle does not say that individuals will pursue whatever action nets them the most money. If such an action is immoral, unethical, or perhaps harms others, an individual may well elect not to pursue it, yet still abide by the tenet above. The tenet takes no position as to the factors that might reasonably constitute a person's "interest." Money might be part of this, but so too might be status, conformity to some set of behaviors deemed to be moral by the individual in question. It might account for the interests of others---family, friends, pets, or even strangers.

Look forward reason back, together with the behavioral tenet suggest that if we can understand what others consider "their interests," we can anticipate their choices and thereby conform our own choices to meet a particular end.  We need not be mind readers, but we do need to be empathetic to anticipate others' choices.

Our hiring game highlighted some of the differences between inside and outside thinking. Inside thinking suggests that, if we see a potential employee with a dazzling resume but a middling interview, we interpret these past successes as signals of quality and therefore ignore our own perceptions. Or, we might go the other way and simply discount past successes altogether, as Somit apparently did during our game.

Outside thinking, however, enables us to interpret the signal content of past choices, to interpret how much weight to give to the resume versus the interview. Early on in the process, hiring choices indeed represent a signal about the interview. With a stream of successes, however, hiring decisions convey no information, since the same choice, hire, is made regardless of the interview result. Awareness of this possibility, what is termed an information cascade, can only be had through empathy--understanding why others made the choices they did.

The rest of the course explores these ideas in two ways. First, given the rules of the game, how can we learn to empathize and thereby predict the actions of others. Second, how can we change the rules of the game to produce a better outcome for ourselves and, possibly, others we care about.

 

How to Win at Battleship

I used to play Battleship with my son, but he doesn't want to play with me any more. He's often wondered how I can consistently win the game. He assumes (and he's right) that, since I'm a game theorist, I've probably figured out some sort of mind-reading trick to be able to intuit where his ships are located. Apart from mind reading, I also rely on an optimal search strategy. Anyway, here's an amusing piece in Slate about a Microsoft employee who has taken this idea to its logical extreme.

http://www.slate.com/blogs/browbeat/2012/05/16/_battleship_how_to_win_the_classic_board_game_every_time.html

Happy Summer

Something to remember the class by. This photo courtesy of Alper.

Have a happy summer and a great career gamers. Please stay in touch and feel free to visit the game theory website and blog for a refresh of key learnings from the class. Also, if you find a need for more game theory in your organization, please reach out. In the past, I've done custom sessions at several companies looking for more outward thinking. Many of these requests came from Game Theory alumni.

Keep using your outward thinking and empathy to build mental models and figure out what course of action to take. Previous game theory alums have said that the tools in the class were essential to career management and successfully leading teams.

Judo in Action: The Pebble Watch

Ran across this piece speculating about the lack of VC support for the Pebble, which is basically a limited version of an iPhone packed into a wristwatch. 

http://battellemedia.com/archives/2012/04/does-the-pebble-cause-a-ripple-in-apples-waters.php

Now this seems like a classic judo. The gizmo itself is underpowered compared to the iPhone, the form factor obviously limits its appeal somewhat. And thus we come to the key question--how should Apple respond? 

Is the Pebble really committed to staying small? How large is the potential consumer base for such a device? Since you need an iPhone to run the thing, is it really a threat to Apple? Of course, Apple can kill it by producing their own Pebble, or they can let the thing go. 

My own guess is that this requires no response from Apple since the iPhone is essential for the thing to work. Apple has, in the past, tolerated thrid party offerings that change the form factor of iPod, such as the many speakers, clock radios, etc. produced for it. These have not hurt iPod at all. I expect that they'll reason analogously in this case. 

Your thoughts?