We have already seen decision making based on expected value and utility functions (of gains and losses). The typical stories consider isolated affairs, but real life is full of connected events. The real question is how and whether prior losses and gains influence the behaviour of the decision-maker.
In gambling, it has been found that prior gains can increase willingness to gamble more (house money effect), and previous losses do the opposite. It is on that premise that Thaler and Johnson conducted experiments and asked the participants the following questions.
- Mr A was given two lotteries. He won $50 in one and $25 in another. Mr B was given one lottery and won $75. Who was happier? 64% of the subjects thought A was happier.
- Mr A received a letter from the tax authorities that he made a mistake in the returns and was required to pay $100. He received another note on the same day for another $50. Mr B got one letter from the authorities for $150. Who was more upset? 75% of the participants thought it was A.
- Mr A’s car was damaged in a parking lot and had to spend $200 on repairs. The same day he won a lottery for $25. Mr B’s car was damaged and he had to spend $175. Who was more upset? 70% answered B.
- Mr A won a lottery for $100, but on the same day, he damaged the rug in his apartment and had to pay $80 to his landlord. Mr B bought a lottery and won $20. Who was happier? An overwhelming majority thought it was B.
Richard Thaler and Eric Johnson, “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice”, Management Science, 1990.
