Monday, January 17, 2011
Why Do People Gamble?
I was in Vegas last weekend, doing field research ;) on utility functions. People clearly like to gamble, and are willing to pay a premium for the exposure to random payoffs with large skew. This is contrary to the usual assumption that people are risk averse, and necessitate a positive expected return to take a gamble. Early on in utility theory, Friedman and Savage (1948) siezed on this anomaly to argue that the curvature of an individual's utility function differs based upon the amount of wealth the individual has. This curving utility function would thereby explain why an individual is risk-loving when he has less wealth (e.g., by playing the lottery) and risk-averse when he is wealthier (e.g., by buying insurance). Harry Markowitz, a former student of Friedman's, argued the implications of the Friedman–Savage utility function were paradoxical. Specifically, its implication that those at the highest level of income would never take risks. His solution was to relate the curvature of an individual's utility function to increases in wealth.
Thus, from the very begining, utility theory was problematic. Solutions had a whack-a-mole tendency to rid one anomaly and create another. The basic problem is that
1) People pay to buy insurance.
2) People pay to gamble.
It's still a puzzle, though every so often a new paper shows up to solve it (eg, Kahneman and Tversky's prospect theory). I think people's paying for risky investments that are a function of skill makes total sense in a search for alpha, discovering one's comparative advantage. Yet, the pure randomness of much gambling--slots, roulette, craps--makes no sense unless you assume people have some belief in luck.