Casinos are real laboratories for researchers in statistics, economics and psychology. The fact that people actually go to Casinos and bet with the probabilities against them is a puzzle by itself. Why are Casinos so popular? How do we decide how much to spend and when to stop? How do we control our impulsive desire to bet one more time? How do we interpret randomness and our otucome when the night is over?
I believe that I could be able explain the whole literature about Behavioral Economics just with Casinos examples. Self-Control problems, Self-Serving interpretations, Reference Points, Risk and Loss Aversion, Bounded Rationality, Heuristics and Biases. The fact that Humans are not Econs (we do not behave like Standard Economics predict, maximizing expected value of lifetime utility subject to budget constraints, without making mistakes and with limitless reasoning power and memory) is crucial to understand some persistent and robust errors that we make while allocating subjective probabilities under uncertainty. I will just enumerate and briefly explain some of these interesting phenomena.
Reference points and value function
Go anywhere in the world to an economics school and ask students how is it possible that people go to Casinos and then buy insurances. All the students will answer the same: they must be different individuals, since every decision-maker has a unique utility function consistent either with risk-averse, risk-neutral or risk-loving preferences. Therefore, people that go to Casinos or entrepeneurs are risk-lovers and do not demand insurance. We all learn this at university, but it is obvious that this is not true. Daniel Kahneman and Amos Tversky explain in their famous article Prospect Theory, that people have value functions that are usually concave for gains and convex for losses, which means that, when probabilities are not too small, people are risk-averse for gains and risk-lovers for losses. When probabilities are small the risk attitude is reversed, since people tend to forget about probabilities when they are too small and focus just on the outcomes (most people prefer a lottery with 0.01% probability of winning 6000 than other with 0.02% probability of winning 3000). Considering that small probabilities are overweighted, people are risk-lovers for gains and risk-averse for losses, which is clearly in line with the fact that people gamble (risk-loving when they can win) and demand insurance (risk-averse when they can lose).
Money Fungibility
Standard economics assumes that money is fungible, which means that people value all money the same and is indifferent between spending $100 that were acquired as part of their wage or found in the street. We all can think examples to demonstrate that money is not completely fungible in our minds. When people go to a Casino with $200 and started the night winning, then they will probably put the initial $200 in their pocket and say that they will continue playing with the gained money, "playing for free". But this will definetely not happen to an Econ! if an Econ wins $300, now he has $500 and there will not be any difference between the initial $200 and the new $300. He will have $500 and will use them in the way that maximizes his expected utility.
Planner and Doer - Self-Control
Behavioral Economics also studies self-control problems, because it is clear that on some occasions people behave in a way that is not good for themselves and, what is even more interesting, people know in advance that this will happen to them. The Planner and Doer framework implies that inside us there is a Planner that is patient, calculative and willing to maximize lifetime utility. Besides, there is a Doer who is impulsive and just focus on the pleasure of the immediate experience, without considering any consequence. Therefore, if a person is going to the Casino and the Planner anticipates that the Doer will make him spend more money than expected, the Planner can control the Doer, making him go with a particular maximum amount of money and without credit cards. Doing this, the Planner can prevent the impatient and impulsive Doer from harming the lifetime utility of the individual.
Self-Serving Bias
Another important fact that leads to more spending than expected in Casinos is the Self-Serving Bias, that makes reference to the fact that people tend to believe that good outcomes were caused by their ability and effort, and the bad outcomes are other´s responsibility or even bad luck. Again, it is easy to think about several examples to illustrate this phenomenon. If a person that is playing in a Casino believes that every time he wins it was due to his ability or perception and every time he losses he believes it was just bad luck, he will probably have overconfidence about his probabilities of winning the next time.
Gambler´s and Hot-Hand Fallacy
When people try to interpret and rationalize randomness, they will always make mistakes. The Gambler´s Fallacy is a well-known effect related with the belief that if something happens more frequently than expected in the short-run, then it will happen less frequently in the near future. Probabilities are the same each repetition, so the belief that the previous outcome cannot be repeated is a fallacy that can make people lose a lot of money.
In addition, the Hot-Hand Fallacy also comes from the need to interpret randomness. If a person has won the first 3 rounds of a random game, he does not have more chances of winning the next one. The fact that someone did well in the past is just luck, and nothing states that the result will be repeated in future repetitions.
In conclusion, this post was just a compilation of mistakes people make when they go to Casinos. Casinos are particularly interesting because people must subjectively assign probabilities to uncertain events and constantly decide between prospects. The above list of examples can be definitely longer, but let´s leave information for future posts...
