Chainstore paradox
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Chainstore paradox (or "Chain-Store paradox") is a concept that purports to refute standard game theory reasoning.
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[edit] The Chain Store Game
A monopolist (Player A) has branches in 20 towns. He faces 20 potential competitors in each town, who will be able to choose IN or OUT. They do so in sequential order and one at a time. If a potential competitor chooses OUT, he receives a payoff of 5. If he chooses in, he will receive a payoff of either 2 or 0, depending on the response of Player A to his action. Player A, in response to a choice of IN, must choose one of two pricing strategies, COOPERATIVE or AGGRESSIVE. If he chooses COOPERATIVE, both player A and the competitor receieve a payoff of 2, and if A chooses Aggressive, each player receives a payoff of 0.
These leads to two theories for the game, the induction (game theoretically correct version) and the deterrence theory (weakly dominated theory):
[edit] Induction Theory
Consider the decision to be made by the 20th and final competitor, of whether to choose IN or Out. He knows that if he chooses IN, Player A receives a higher payoff from choosing cooperate than aggressive, and being the last period of the game, there are no longer any future competitors whom Player A needs to intimidate from the market. Knowing this, the 20th competitor enters the market, and Player A will cooperate.
The outcome in the final period is set in stone, so to speak. Now consider period 19, and the potential competitors decision. He knows that A will cooperate in the next period, regardless of what happens in period 20. Thus, if player 19 enters, an aggressive strategy will be unable to deter player 20 from entering. Player 19 knows this and chooses IN. Player A chooses cooperate.
Of course, this process of backwards induction holds all the way back to the first competitor. Each potential competitor chooses IN, and Player A always cooperates. A receives a payoff of 40 (2*20) and each competitor receives 2.
[edit] Deterrence Theory
Player A can get more than 40. Suppose Player A finds the induction argument convincing. He will decide how many periods at the end to play such a strategy, suppose 3. Then in periods 1-17, he will decide to always be aggressive against the choice of IN. If all of the potential competitors know this, it is unlikely potential competitors 1-17 will bother the chain store, and risk a safe payout of 1, to get an assured 0. If a few do test the chain store early in the game, and see that they are greeted with the aggressive strategy, the rest of the competitors are likely not to test any further. Assuming all 17 are detered, Player A receives 91 (17*5 + 2*3). Even if 10 competitors test Player A's will, he still receives 41 (7*5 +2*3) which is better than the induction (game theoretically correct) payoff.
[edit] The Chain Store Paradox
The logical inescapability of the induction argument is unable to destroy the allure of the deterrence theory, and deterrence is what most players and economists versed in game theory will play if they play this game.
Selten's response to this paradox is to argue that the idea of "deterrence", while irrational by the standards of Game Theory, is in fact an acceptable idea by the rationality that individuals actually employ. Selten argues that individuals can make decisions of three levels: Routine, Imagination, and Reasoning.
[edit] Selten's Levels of Decision Making
[edit] The Routine Level
The individual uses their past experience of the results of decisions to guide their response to choices in the present. "The underlying criteria of similarity between decision situations are crude and sometimes inadequate". (Selten)
[edit] The Imagination Level
The individual tries to visualise how the selection of different alternatives may influence the probable course of future events. This level employs the routine level within the proceedural decisions. This method is similar to a computer simulation.
[edit] The Reasoning Level
The individual makes a conscious effort to analyse the situation in a rational way, using both past experience and logical thinking. This mode of decision uses simplified models whose assumptions are products of imagination, and is the only method of reasoning permitted and expected by game theory.
[edit] Decision Making Process
[edit] The Predecision
One chooses which method (routine, imagination or reasoning) to use for the problem, and this decision itself is made on the routine level.
[edit] The Final Decision
Depending on which level is selected, the indiviudal begins the decision procedure. The individual then arrives at a (possibly different) decision for each level available (if we have chose imagination, we would arrive at a routine decision and possible and imagination decision). Selten argues that indiviudals can always reach a routine decision, but perhaps not the higher levels. Once the individuals has all their levels of decision, they can decide which answer to use...the Final Decision. The final decision is made on the routine level and governs actual behaviour.
[edit] The Economy of Decision Effort
Decision effort is a scarce commodity, being both time consuming and mentally taxing. Reasoning is more costly than Imagination which, in turn is more costly than Routine. The highest level activated is not always the most acurrate since the individual may be able to reach a good decision on the routine level, but makes seriously computational mistakes on higher levels, especially Reasoning.
Selten finally argues that strategic decisions, like those made by the monopolist in the chainstore paradox, are generally made by on the level of Imagination, where deterrence is a reality, due to the complexity of Reasoning, and the great inferiority of Routine (it does not allow the individual to see herself in the other player's position). Since Imagination cannot be used to visualise more than a few stages of an extenisive form game (like the Chain-store game) individuals break down games into "the beginning" and "towards the end". Here, deterrence is a reality, since it is reasonable "in the beginning", yet is not convincing "towards the end".
