Thursday, August 30, 2007

Preliminary thoughts on gambling economics

Recreational gambling is a socially disapproved of activity. That it yields entertainment benefits in the form of service flows rather than material outputs should not be the reason for this disapproval. Services rather than material outputs are a significant source of consumption pleasures for most people – many enjoy viewing football matches, pictures in art galleries or pole dancers in New York nightclubs - these are service flows also. The difficulty with gambling is that it can be behaviourally addictive and – because commercial gambling offers a series of unfair bets – this generally will lead to financial ruin if the amount staked is large enough. A significant fraction – perhaps around 10% - of the Australian gambling population comprise ‘problem’ gamblers in this sense.

Poker machines in particular are observed to be the most addictive forms of gambling and accordingly one of the major growth areas in commercial gambling in Australia.

I don’t want to argue the case for government intervention in this post – there are well-worn arguments about whether restricting access to gambling is an instance of ‘nanny statism’ or not. Let me take the case for intervention as given and look at how best to achieve that.

The standard approach by almost all governments has been to restrict the number of gambling outlets or the number of gambling machines either by setting absolute numerical quotas, by limiting the availability of venues and machines in particular locations or by pursuing both of these strategies. In Victoria the ‘both’ strategy is being employed.

Limiting the number of gambling venues and the number of gambling machines at venues then provides monopoly rents to the owners of venues and machines which the government then subjects to various taxes.

It is known that a monopolist has incentives to raise the price of a service above its marginal cost. Price here measures the expected loss rate on a $1 gamble and, under monopoly, this will be higher than under competitive conditions. Proportional taxes on venue profits or fixed taxes per machine or venue under monopoly will not disturb this price but taxes on revenues generated or on the gambling price itself will tend to further raise the price of gambling services. Any move toward increased price due to the taxes will increase the inefficiency losses associated with monopoly provision.

Note that these policies have nothing directly to do with the issue of compulsive or problem gambling. It simply returns to the state some of the rents the monopolist will gain from government imposed restrictions on competition.

The conventional economic theory of externalities would suggest a case for having a competitive gambling industry and, instead of regulating to achieve monopoly power, levelling a tax on the price charged for a gamble - on the expected loss - that would force the gambling operators to internalise the social costs gambling imposes on the community. This realises the social optimum as illustrated in the figure.

Here the demand for gambling is indicated D, the marginal cost of providing gambling services is MC (this is supposed constant, allowing it to vary would change little), the average cost of providing the gambling service is AC=MC, the price of a gamble (the expected loss) is P and the volume of gambling is q. The social marginal cost of gambling that occurs as a consequence of behavioural addictions is SC which exceeds MC. Here SC is supposed to increase faster than MC because with high levels of gambling demand more people are supposed to be dragged into ‘problem gambling’ with consequent social problems for families and so on. SC might also capture monitoring costs from authorities concerned with the use of gambling facilities for illegal purposes such as money laundering the proceeds of crime.

Corresponding to prices pm, psc and pc are levels of gambling consumption qm, qsc and qpc.

An unregulated gambling industry would result in the high level of gambling qc with low gambling losses per gamble pc. There would be a high level of social costs associated with this pattern of gambling described by the deadweight losses C. Levying the tax on the cost of gambling tc would restore gambling levels to their socially optimal levels qsc supplied at a tax-inclusive price psc.

The competitive approach is not however the approach to gambling governments typically enforce.

Instead they provide service providers with monopoly status which encourages them to provide the gambling output qm at price pm with the government levying taxes tm (much larger than tc) to recoup the monopoly profits – the firms have incentives to act as monopolists but, in theory at least, the government accesses most profits. The deadweight loss to the community from monopoly provision is the area A+B. It is also clear that with this level of provision the government’s tax take might even fall.

This picture suggests that the current approach to gambling regulation will not realise efficiency. It reduces the level of gambling but it does so excessively and produces a cost of gambling that is too high. It reduces the non-internalised social cost of gambling but at the expense of a more than proportionate increase in the private costs.

One objection however that one might make to this analysis is that the gross benefits from gambling to gamblers are treated here as the area under the demand curve. This is true only for informed consumers who do not face behavioural addiction or compulsion issues. The Productivity Commission’s report on gambling adjusted for this problem by shifting the demand curve downwards to cut out the compulsive gambling group. This will reduce the quantity of gambling services the community would seek to deliver and, if costs are increasing, will increased the targeted loss rate on gambling in the direction that heads toward the monopoly price even if a competitive type of equilibrium was sought.

The regulator could seek to retrieve the situation by regulating the loss rates allowed at gambling venues and pegging them at the competitive tax-inclusive price psc. This makes the monopolist resemble a competitive firm but creates an excess demand for gambling services at the going price and still leaves deadweight losses. If one thinks about a specific gambling venue one could imagine that queuing or other rationing devices need to be employed by operators to balance machine availability with demand.

So where do I end up? Do we want a society where citizens are offered many low priced gambles or a society where the same citizens are offered fewer gambles at a higher price? Loss rates are higher in the latter situation, which will deter some people from gambling, thereby reducing the overall incidence of problem gambling but at the same time penalising those who do continue to gamble. Competitive gambling scenarios provide improved environments for those who can manage their gambling instincts sensibly but leave society as a whole with more problem gamblers who head downhill more slowly because of lower gambling costs than occur with monopoly.

One incomplete defence of government regulatory policies is that profits are easier to identify than social costs. Even if a competitive gambling industry with a low competitive tax tc outperforms a monopolised industry with tax tm it is certainly much easier to identify tm than tc.

Another defense of current policies is that making gambling widely available in the community creates a demand for gambling entertainments that the government regards as unhealthy. Thus the government restricts supply to limit demand. This might be correct but it moves away from standard arguments based on the premise that consumers should be sovereign.

More than usually - comments are welcome.


Appu said...


Great analysis. When looking at socially disapproved activities, some legal, some (ecstasy tablet, AFL players & drugs etc) not, the debate on the levers a society through it's government can pull is fascinating.

The government's own agenda in this is unclear (I heard a figure of 10% mentioned as the percentage of total revenue that gambling brings in in NSW).

Would the points you have made apply to the trade in illicit drugs? Would the price come down and with it the ability for addicts to get a fix be safer and easier?


Gambling like most of these socially disapproved activities is frowned upon in the "East" with society frowning upon these activities. In fact, I think betting is totally banned in the land of "John" the weather report guy - India. China has it's reserved enclaves for gambling and makes a mozza out of mainlanders using the facilities.

If as it seems it is such a vital part of the human make up, it should be made easier and cheaper - like drinking coffee so those with an itch can scratch it.

Then again shouldn't the same apply for drugs?

hc said...

The figure drawn is wrong - it shows the wrong monopoly output. Too late - I'll fix tomorrow.

hc said...

Correction now made to figure.

derrida derider said...

appu given the propensities of many Chinese people I have known it's an absolute joke for the Chinese government to ban gambling. Love of a flutter is more part of the stereotypical Chinese than it is of the stereotypical Australian.

But Harry's analysis is a good one. It's a problem with lots of things in life - the great majority of partakers get pleasure and little harm out of it while a minority are destroyed by it (Harry, like me, enjoys a good red. But our pleasure is offset by the thought of those horrible deaths by oesophageal vareses ...).

Yobbo said...

"So where do I end up? Do we want a society where citizens are offered many low priced gambles or a society where the same citizens are offered fewer gambles at a higher price?"

This isn't the choice.

Even in the system we have now, you could gamble your entire life savings away tomorrow without any problems.

The only difference is you will be getting a worse return because of regulation.