Americans spend more than $100 billion a year on lottery tickets, which is more than what they spend on cigarettes or on music, sports tickets, movie tickets, books, and video games combined.
With a high rate of negative expected returns and a large variance in prizes, lotteries aren’t a rational financial decision for consumers by any measure. But people keep buying more tickets every year, although the odds of winning a jackpot are about 1 in 300 million.
For Wharton economist Benjamin Lockwood, who studies how governments use taxes and other policy levers to change behavior, the inherent contradiction in lotteries proved too intriguing a topic to pass up. His co-authored paper, “What Drives Demand for State-Run Lotteries? Evidence and Welfare Implications,” explores this understudied and controversial aspect of the economy to come up with new answers. It’s also the first to set a framework for an optimal lottery policy, one that accounts for the behavioral biases of consumers and the concerns about the distribution of wealth in society.
“As a researcher, you’re excited when you are working on something and genuinely don’t know the answer, and you can shed light on it,” Lockwood said. “This is an area where people have completely different arguments. Most economists are very uncertain about whether lotteries are beneficial. It’s amazing that it’s such a huge category of spending and consumption, yet we don’t know if it’s making people better off or not.”
The paper was published in July in The Review of Economic Studies. Co-authors are Hunt Allcott, sustainability professor at Stanford University’s Doerr School of Sustainability; Dmitry Taubinsky, public economics professor at the University of California, Berkeley; and Afras Y. Sial, former research coordinator at Wharton and doctoral candidate in economics at UC Berkeley.
Lockwood identified three key findings from the study:
- Consumers think differently about lotteries than they do about alcohol, cigarettes, soda, and harmful products subject to so-called “sin taxes.” Most don’t consider buying a lottery ticket to be a mistake.
- Behavioral biases, including financial illiteracy, prompt lower-income consumers to buy more tickets. Households with incomes below $50,000 spend an estimated 30% more on tickets than households with incomes above $100,000.
- Based on modeling, the optimal implicit tax rate for lotteries is close to the current designs of Mega Millions and Powerball, the two biggest games in the U.S.
“People enjoy playing the lottery, and it’s important to take that seriously.”— Benjamin Lockwood
For Lottery Lovers, Dream Is Worth Risk
From a behavioral economics perspective, buying lottery tickets doesn’t make much sense. “It’s a risky financial product where you’re expected to lose money on average,” Lockwood said. So, why do people choose to spend their hard-earned dollars on lottery tickets instead of other goods or services where the exchange is certain? According to surveys conducted by the authors, the cost of a ticket is a small price to pay for a dream. People love thinking about what they would do with the money or how a jackpot would change their lives. Unlike how they responded to survey questions about smoking, drinking, or gambling, most consumers did not express regret or remorse about buying tickets and were comfortable with what they spent. These feelings of delight and utility mean that seeing lotteries only as a financial asset is a fundamental misunderstanding of it as a product, the professor said.
“People enjoy playing the lottery, and it’s important to take that seriously,” Lockwood said. “It’s a mistake to think only about the probabilities of winning and prize values in the same way it would be a mistake to try to understand whether video games are good or bad by focusing only on the quality of the graphics.”
Although most consumers consider lotteries as entertainment, there are those who overspend. The scholars found a number of behavioral biases that lead people to spend more than they are comfortable with, including poor self-control, a lack of understanding of statistics, and low financial literacy. In their analysis, they estimated that Americans would spend 43% less on lotteries if they had perfect self-control, had the financial literacy and statistical ability of the highest-scoring people in the survey sample, and had correct beliefs about expected returns.
“People aren’t the rational actors that come out of an Econ 101 textbook. They sometimes make mistakes, are subject to temptation, or don’t totally understand something,” Lockwood said. “Once you start taking that fallibility seriously, it changes how you design policy. And policy is easier to see if you understand that and have that kind of framework in mind.”
“If I had to take it or leave it with existing state-run lotteries, I would probably leave them in place.”— Benjamin Lockwood
What’s the Best Lottery Design?
Lotteries have long been criticized as a regressive tax on the poor, and the study does show that lower-income consumers spend more on lottery tickets than higher-income consumers. But there is also some social welfare benefit. In 2019, lotteries generated $25 billion in state revenues – that’s more than the money raised by federal estate or tobacco taxes, and just under the revenue of the federal fuel tax.
The researchers wanted to design a lottery model that balances the desires of consumers with the concerns about social harm. They identified two critical elements: ticket price and jackpot size. Perhaps not surprisingly, consumer demand for lottery tickets surges when jackpots are higher, but doesn’t fall by the same degree when the ticket prices increase. With that behavior bias in mind, the scholars then focused on the 43% — that’s the estimated decrease in lottery spending if consumers were perfectly rational.
After extensive calculations, they determined that the most socially optimal lottery design is similar to the current Mega Millions and Powerball. The taxes on winnings are high, which is consistent with the tax rate it takes to corral consumption but not stifle it completely.
“I don’t want to be misunderstood to say everything is great with lottery tickets. But if you are going to try to use a tax to correct that behavior, then it seems the existing taxes are right,” Lockwood said, adding that other policies could be implemented to curb overspending, such as ticket quantity limits.
For the professor, who has done extensive research into how taxing works to discourage unhealthy behaviors, the project was revealing. Lotteries are unique among the “sin” goods he has studied.
“I came into this being pretty skeptical that lotteries have much socially redeeming value. One thing I became convinced of is the real enjoyment that people get out of them,” he said. “If I had to take it or leave it with existing state-run lotteries, I would probably leave them in place. That said, I think there are some improvements we could make to help folks who have a problem with overconsumption.”
