North Carolina will be making the 2-year-old lottery more attractive to play. As part of the just-concluded state budget, the lottery rules were changed to permit higher prize payouts. The hope is that better winnings will increase ticket sales and increase profits, or net proceeds, to the state.
But wait a minute. Isn’t this faulty thinking? If the state pays out more in lottery prizes, won’t the amount it keeps decline rather than increase? Won’t higher prizes be bad for state coffers, even though they’re good for lottery players?
This is a question that’s common to more than state lotteries. In fact, it’s one of the most fundamental questions in economics — indeed, a question that business executives ask all the time. Can decreasing the price of a product or service actually increase profits for the business? Or, as common sense would suggest, can profits only be expanded if the price goes up?
The answer, fortunately or unfortunately, is, it depends. If a grocery lowers the price of bread by 20 percent a loaf, and twice as many loaves are sold, even though the grocer will make less profit per loaf, she will make more total profits. But if, when bread prices are cut 20 percent, only 5 percent more loaves are sold, not only will the grocer make less profit per loaf, but the total profits from selling bread will also drop.
If you hang around economists like me, you’ll find we have a name for this concept — price elasticity. It’s really a simple idea. Think of elasticity as meaning “stretch,” in the sense of how much purchases will stretch when the price changes. Products or services where purchases stretch a lot when the price changes are called price elastic. Products or services where purchases stretch very little when the price changes are called price inelastic.
Gasoline is a good example of a price inelastic product. Because most of us are locked in to our driving patterns, the mileage we drive, and the gallons of gas bought, will change relatively little when gasoline prices jump. Alternatively, hog dogs are more likely to be a price-elastic product, because when their price rises, many people will switch their purchases to hamburgers.
Now let’s get back to the lottery. Evidence indicates that, when a state lottery is relatively new, playing it is price-elastic. This means increasing the prizes or improving the odds of winning, which effectively lowers the price of playing, will stimulate enough new ticket sales as to increase the lottery’s net revenues, after prizes and other costs, to the state. So North Carolina’s decision to permit higher prize payouts was a logical way to bump up lottery revenues.
There is a “but” to this story. The evidence also suggests that as lotteries age, they can change from being price-elastic games to price inelastic games. This happens probably because people get used to the lottery: It is no longer new, different, or exciting. This also means increasing the prizes or odds of winning won’t necessarily work to augment lottery profits to the state. It would do just the opposite. Profits to the state would drop.
The importance of the price-elasticity concept to the lottery actually has application to all sources of public revenues. Take the controversy over tax rates, and whether lowering a tax rate can actually increase tax revenue. The answer depends on the price elasticity of the tax. Taxes that are price-elastic, meaning lowering the tax causes a large increase in the economic activity being taxed, will generate more revenues at lower rates. But taxes that are price-inelastic will yield less tax revenues when the tax rate is cut.
Of course, as an economist, I’m convinced that economics and economic concepts have wide applicability to many private and public decisions. But with this explanation of the thinking behind changing North Carolina’s lottery rules, maybe you’ll decide I’m not too far off base.
Michael L. Walden is a William Neal Reynolds distinguished professor at North Carolina State University and an adjunct scholar of the John Locke Foundation.