Tuesday, May 8, 2007

Playing the Rent III—Lotteries and Casinos

In reading over the previous essay on tolls, I think I gave the subject short shrift and I’ll have to cycle back to it at some point. I do notice, for example, in this week’s Economist, (May 3rd, 2007) a news story, “Rules of the Road,” that references a paper on the sort of toll-taking behavior I described. In this case it was extortion from a series of military checkpoints in Indonesia, but the economics of checkpoint extortion and toll-taking should be the same:

The Simple Economics of Extortion: Evidence from Trucking in Aceh”, by Benjamin Olken and Patrick Barron.

Also, to backfill yet some more about what I’m doing here, I’m looking for alternative models, and especially nomenclature to what is nowadays commonly called “rents” by economists. The term has seemingly come to mean “the difference between price paid for a good or service and what would exist in a purely commodity (perfect competition) model of the transaction." I’ve already noted that this makes what we usually call rent a subset of “rent.” I also realized last night that, since ordinary rent usually also includes payments for some service functions (e.g. repairs and maintenance), then not all of what people usually call rent is “rent” in the jargon sense.

Sloppy nomenclature makes for sloppy thinking.

Anyway, to one of my favorite subjects, chance and randomness, and its problem child, gambling.

From the standpoint of conventional equilibrium “rational expectations” economic theory, the lottery makes no sense whatsoever. There is an easily calculated probabilistic “expected value” of a one dollar lottery ticket and that value is less than one dollar. So what gives?

Behavioral economics gives us some hints, and even conventional economics allows for “psychic rewards” and “entertainment.” The fact is that holding a lottery ticket assists in the holder’s ability to dream about how nice it would be to be rich. The lottery ticket adds just that little dollop of realism that we writers of fiction call the “willing suspension of disbelief.”

It’s true that there are some pathological cases where people spend the rent money on lottery tickets, etc., but those come more under the heading of obsessive-compulsive disorder than anything else. Some people also send the rent money to televangelists, and for rewards that are somewhat less likely than a Powerball Jackpot.

But lotteries aren’t at all the most popular forms of gambling, and one doesn’t play craps, roulette, or bet on the ponies or other sports because one dreams of getting rich. No those players crave action.

In action play, the jackpot or the “big score” may exist in the back of the mind, but the real payoff is the adrenaline rush. The Kentucky Derby is called “The Most Exciting Two Minutes in Sports,” a phrase no doubt coined by someone with money on the nose.

There is this notion in economics of a “risk premium,” which is the spread between stocks and bonds, the latter being safe and boring, the former being risky. Supposedly, investors are “risk averse” so that explains the difference.

But let’s consider the possibility that at least some individuals are not “risk averse” but rather seek risk. They crave the action, in other words. Of course, this is hardly an original observation; we have words for such people: speculators, traders, and at its most honest, gamblers.

The commodities pits are notorious for the action guys, but over the past couple of decades, more and more of the action ahs been spilling over into markets generally. I ran across several papers by the authors Owen A. Lamont and Richard H. Thaler several years ago, looking at the odd behavior of 3Com and Palm Inc. stock during the period when the latter was being carved out of the former. Here’s one of them: Anomalies: The Law of One Price in Financial Markets.

The upshot of Lamont and Thaler’s work was that certain stock option and warrant behaviors made no sense whatsoever from the standpoint of conventional stock valuation. Instead, the stock in the new company was so thinly traded that it was susceptible to wild swings in pricing, and that attracted, well, basically gamblers. Shares of the thinly traded stock were the “chips” needed to get in the game, and most of the players only held onto them (or horted them) for a few hours.

Why do you play this game? You know it’s rigged. Yeah, but it’s the only game in town.

In The Big Casino, I compared American economic exuberance to casino gambling and lottery payouts, and I think there’s a great deal of truth to that. If people will pay to play a game that is against them, just so they can dream, how much better is it to play a positive-sum game, where the pie expands, so, theoretically, everyone can be a winner.

In practice, of course, a lot of people still wind up losing the rent money. That is a testament to the power of dreams. But you don’t look at the guy who makes 10 passes in a row at the craps table and say he’s collecting “rents.” No, the guy to watch is the casino operator. He’s working what’s called “house odds.”

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