Gambling Addicts and Economic Theory

With a headline like this, everyone probably can guess where I'm going. Why play games with a negative expected return? Over the long run, you're almost guaranteed to lose money. A rational consumer wouldn't repeatedly do something like that. But I've found another defiance of economic theory, even when you look at gambling as a valuable good (consumed by gamblers).

Temporarily look at gambling as an entertainment expense. Sure, it costs money, but so does a movie, and people enjoy gambling a lot. Even if you do it too much, a little bit still makes sense in your life if you enjoy the activity enough (just like shopaholics need to stop impulse buying, but don't need to stop purchasing things from stores entirely).

OK, now let's switch gears for a minute. A fundamental tenant of financial and economic theory is that optionality has value. It's always better to have the option to do something than to not have the option, because if you DO have the option, you're never worse off, and in some potential future states of the world, you are demonstrably better off. Higher expected value, higher present value. It's why stock options are valuable (very valuable in this high-volatility market), and part of the explanation why an American call on a stock is worth the same as a European call on a stock (if you don't know what that means, don't worry about it).

Now combine those two points with this report from the Philadelphia Inquirer: New Jersey, home of Atlantic City, just added their one-thousandth (1,000th) name to a special list of persons banned from entering casinos. What makes this list so special is that it's voluntary. 1,000 individuals have gone out of their way to ask to have the option to enter a casino and gamble taken away from them.

At the core, I do very much understand and appreciate the impulse. It's the same logic that causes many people to avoid being in the presence of unhealthful foods. Remove the temptation, remove the possibility, and you can assist your better self in a mind-over-matter struggle for identity and self determination. Sure the option to have a donut has value, just as the option to gamble, since both goods are capable of producing great joy. But they're both bad for people in excess, and some people can't even trust themselves not to over-consume the good until their marginal return is negative.

What can we infer from this? Are there any lessons, or is it just an interesting oddity? I have a few thoughts:

When markets become inefficient, when the decisions of one person can impact the outcome of a system, or when human psychology--even financial psychology--is a major factor...don't count on rationality. This may be obvious, but what most people don't consider is that if you're counting on irrationality, it may be easy to predict what type of irrationality you're dealing with. The way I see it, there are two types of overriding irrationality: Overreaction and Inflated Discount Rates.

Overreaction is fairly easy to understand. People need to cut back on gambling, so they slam on the breaks and ban themselves from casinos (in some cases it may be the only way to avoid under-reacting, which carries with it worse consequences, but in some cases it may be to the forfeiture of consumer surplus, or value). We see it in less dire straights. My brother wants to be healthy, so he now eats nothing but egg-white omelets, steamed chicken, and vegetables. A little bit of bad economic news comes out, so the markets crash 4% only to bounce back 3% the next day.

Inflating a discount rate is a little harder to understand and see in every day life, but basically what it means is that people increase the impact time has on diminishing the value or detriment associated with a future gain or loss. A dollar today is worth more than a dollar a year from now (because even if you don't want to spend the dollar for a year, you could still put it in the bank and wind up with more than you started--also you have the option of spending it now or later, while the dollar a year from now only lets you spend it later, and optionality has value). But a dollar today is only worth maybe a dollar and a penny a year from now, or a dollar and four cents...certainly not more than a dollar and a quarter. But when people are being irrational, they place immediate value disproportionately above future value, and make bad decisions. A donut now tastes good, and diabetes is a long way off, even if the pain it causes is thousands of times greater than the enjoyment reaped from the donuts (people also inflate discount rates when the connection isn't abundantly clear). But when people are scared or are being irrational, they often focus on the present at the expense of the future. In my experience, recognizing this tendancy can help to understand irrational behavior (such as the gambling addiction itself).

Ideally a person aware of these tendancies can balance them out, and the business student inside me suggests playing poker with people who can't.