A strong case can be made that Adam Smith is the first behavioral economist, for he diagnoses not one but two major cognitive quirks in Paragraph 26 of Chapter 10 of Book I of The Wealth of Nations: the overconfidence effect and optimism bias. Moreover, according to the Scottish philosopher-economist, our overconfidence in “our own good fortune” distorts our risk-calculus abilities, causing us to overvalue potential rewards (“the chance of gain”) and to underestimate potential risks (“the chance of loss”):

“The over-weening conceit which the greater part of men have of their own abilities is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own good fortune has been less taken notice of. It is, however, if possible, still more universal. There is no man living who, when in tolerable health and spirits, has not some share of it. The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.” (WN, I.x.26)

In the next two paragraphs of his magnum opus (Paragraphs 27 & 28 of Book I, Ch. 10), Smith presents two textbook examples of our inability to make accurate risk assessments in the real world: (1) state-run lotteries, and (2) insurance policies. With respect to lotteries, Smith explains why the expected value of a lottery ticket is always a negative sum:

“The world neither ever saw, nor ever will see, a perfectly fair lottery; or one in which the whole gain compensated the whole loss; because the undertaker could make nothing by it. In the state lotteries the tickets are really not worth the price which is paid by the original subscribers, and yet commonly sell in the market for twenty, thirty, and sometimes forty per cent advance…. There is not, however, a more certain proposition in mathematics than that the more tickets you adventure upon, the more likely you are to be a loser. Adventure upon all the tickets in the lottery, and you lose for certain; and the greater the number of your tickets the nearer you approach to this certainty.” (WN, I.x.27)

In other words, the house always wins! So, why do people buy lottery tickets? Emotional reasons, pure and simple. We buy lottery tickets out of the “vain hope” we might win a life-altering jackpot, or in the immortal words of Adam Smith:

“The vain hope of gaining some of the great prizes is the sole cause of this demand [for lottery tickets]. The soberest people scarce look upon it as a folly to pay a small sum for the chance of gaining ten or twenty thousand pounds; though they know that even that small sum is perhaps twenty or thirty per cent more than the chance is worth.” (WN, I.x.27; my emphasis)

In short, people are motivated by the size of the prize, not the mathematical probability of winning. By contrast,

“In a lottery in which no prize exceeded twenty pounds, though in other respects it approached much nearer to a perfectly fair one than the common state lotteries, there would not be the same demand for tickets.” (WN, I.x.27)

Now, what about negative lotteries, like maritime insurance or fire insurance? I will discuss Adam Smith’s astute observations on insurance in my next post. (To be continued…)