I should have reported on this Snowberg-Wolfers paper long ago: [A] longstanding empirical regularity is that betting odds provide biased estimates of the probability of a horse winning|longshots are overbet, while favorites are underbet. Neoclassical explanations focus on rational gamblers who overbet longshots due to risk-love. The competing behavioral explanations emphasize the role of misperceptions of probabilities. We provide novel empirical tests that can discriminate between these competing theories … Using a new, large-scale dataset ideally suited to implement these tests we find evidence in favor of the view that misperceptions of probability drive the favorite-longshot bias, as suggested by Prospect Theory. Along the way we provide more robust evidence on the favorite-longshot bias, falsifying the conventional wisdom that the bias is large enough to yield profit opportunities (it isn't) and that it becomes more severe in the last race (it doesn't).
I think that a proper explanation of why long-shots are overplayed should also explain why people play the lottery at all. This means that framing it as a problem of overestimating odds is probably a false start. People know the lottery odds, and still play.
More likely, we misunderstand their utility functions, and they don't map returns linearly into utility.
For example: If instead of thinking about wealth on a continuum of net worth, you class people into "poor" and "rich"; and you are "poor"; then playing the lottery has no downside. It can move you from "poor" to "rich", or from "poor" to "poor".
Philip: the linked paper takes into account what you discuss, viz that utility functions are not linear in money.
I think that a proper explanation of why long-shots are overplayed should also explain why people play the lottery at all. This means that framing it as a problem of overestimating odds is probably a false start. People know the lottery odds, and still play.
More likely, we misunderstand their utility functions, and they don't map returns linearly into utility.
For example: If instead of thinking about wealth on a continuum of net worth, you class people into "poor" and "rich"; and you are "poor"; then playing the lottery has no downside. It can move you from "poor" to "rich", or from "poor" to "poor".