Media Briefings

GAMBLING REGULATIONS: New analysis of the impossibility of protecting risk‐takers

  • Published Date: January 2018

Is it possible to regulate gambling without significantly restricting other sales mechanisms such as auctions? Not according to research by Toomas Hinnosaar, which is forthcoming in the Economic Journal.

His study shows that when people like to gamble and sellers can use flexible auction formats, it is always possible to extract large profits from gamblers. Protecting risk-takers from paying large sums requires establishing significant constraints on possible auction formats – either in the form of maximum bids or money-back options, both of which may lead to inefficiencies.

The research is motivated by the observation that while gambling is heavily regulated in most countries, there is a grey area between gambling and other sales mechanisms.

Gambling is defined by three elements: chance, prize and consideration (a fee paid by the participant). A sales mechanism that lacks any of these elements is not considered gambling.

For example, several New York Times articles have focused on house sales that take place via essay contests, where the writer of the best essay gets the house for free but the seller's revenue is generated through entry fees. This is not treated as gambling since the outcomes rely on skill rather than luck.

Further examples are the sweepstakes contests you often find in grocery stores, where purchasing a product may win you a valuable prize. Sweepstakes contests are not considered gambling if the ‘no purchase necessary’ clause is satisfied – in other words, if participants can enter the contest for free.

Online sellers have successfully exploited this grey area by concocting novel auction formats. One is the penny auction, where each bid placed by online bidders increases the selling price of an item by one cent, but placing the bid requires them to pay a significant bid fee. Penny auctions are appealing to participants who are willing to incur significant bid costs in the hopes of winning a product at a discounted price.

This auction format tends to have highly random outcomes and is often highly profitable for the seller. But both the Gambling Commission in the UK and the European Commission have stated that penny auctions are governed by rules applied to auctions rather than gambling.

The new study takes these arguments to their logical extreme, and proves that applying the three elements that lawyers normally use to determine whether a mechanism is gambling or not is too weak a requirement to be effective. Even if regulations only allow mechanisms that do not violate any of the three requirements, sellers can still construct risky auction formats that are highly appealing to risk-loving buyers, and also highly profitable for the seller.

The result combines two key assumptions. The first is that at least some people become insensitive to additional monetary losses once they lose enough money. This assumption is satisfied, for example, under cumulative prospect theory preferences, which are widely used in economics and supported by experimental evidence.

The second assumption is that the seller can use at least non-random winner-pays auctions. In these auctions, bidders submit bids, and the highest bidder gets the object and pays an amount that depends only on the bids. There is, therefore, no randomisation (no element of chance), no participation fee (no consideration) and the only prize is the object sold. But the other bids are still sufficient to create randomness that is appealing to risk-lovers and extracts high profits.

ENDS


Notes for editors: ‘On the Impossibility of Protecting Risk‐takers’ by Toomas Hinnosaar is forthcoming in the Economic Journal.

Toomas Hinnosaar is at the Collegio Carlo Alberto in Turin.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); or Toomas Hinnosaar via email: toomas@hinnosaar.net