Why do people gamble? A straight application of prospect theory says that when offered the choice of $1 with certainty versus a gamble with expected value of, say, 85cents then it is rational to stay with the $1. Yet the gambling industry is alive and well and has been for thousands of years. Why?
Milton Friedman famously posed this question and concluded that gambling exists because people enjoy the experience. He surmised that the average gambler knows that they expect to lose money but they enjoy the experience watching horses or being the patsy in a poker game with a bunch of sharpies. Technically, Friedman’s argument is that some people derive utility from gambling thereby qualifying it as a consumption good. By adding gambling into the utility function it follows that each economic agent will consume their gambling experience to the extent that their marginal utility matches the marginal cost of the good and, indeed, suppliers of gambling services will be lured by the profit opportunity this utility creates to build the industry.
The idea that we can stuff anything we want into the consumer’s utility function to explain seemingly inexplicable behaviour is both ingenious and unfulfilling. On the one hand it makes sense since there is definitely some enjoyment being generated at the racetrack. On the other hand, stuffing everything into the utility function means that you can explain everything, and I have said many times that a theory that explains everything, in fact explains nothing.
Not surprisingly, Fiat Money has also had the utility function treatment, being, as it is, nothing but worthless paper (now electrons) that can be supplied in any quantity by a Central Bank. The ‘Money-in-the-utility-function’ argument is a more difficult case to make than is gambling since any utility derived is indirect at best. There are also millions of financial assets backed by real assets, that offer a positive rate of return, so why not put them in the utility function as well? Money-in-the-utility-function is a hard case to make…which brings me to Crypto and why it continues to exist.
On the face of it, cryptocurrencies should be bucketed in with fiat money as a competing, non-convertible media of exchange. The traditional view is that the easiest and most widely accepted medium will dominate all others, thereby reducing the number of accepted currencies down to one. If this were the case then the US dollar would have fought off the crypto threat years ago. But this is not the case – after a decade we still have Bitcoin and a plethora of others. True fortunes have been made in Crypto and the industry continues to produce astoundingly successful variations such as smart-contract decentralised finance markets and Non-Fungible Tokens. While purists will point out that Crypto coins are basically worthless since they lay claim to nothing, there is a ‘fun-factor’ in crypto for many users (investors?) in that they seem to derive some utility from being able to say they own crypto and one day they will buy a Tesla with it. So whereas it is difficult to make a case for adding the US dollar to the utility function, it is very easy to make the case for crypto and its derivatives. Positive utility builds demand and demand underwrites the industry that grows up to satisfy that demand.
Despite the coin scams, the rug-pulls, the inability to access the mainstream banking payments systems or, more simply, the inability to buy an espresso with a fraction of bitcoin, there is a ‘fun factor’ which keeps crypto alive and thriving. So if the ‘fun factor’ justifies crypto’s very existence by virtue of the utility it provides and the related demand it generates, what will cause it to lose it’s source of value? The ‘fun factor’ itself is the issue here.
Ironically, crypto’s undoing at some point in the future (if indeed it does get undone) would be it’s becoming generally accepted, pedestrian, boring and therefore no longer fun.
I cannot see Central Bank crypto’s being successful for the reason that they will be regulated and boring. Every hacker’s dream would be to crack into USDcrypto so it would be arguably less safe than Dogecoin. There wouldn’t be a cool community to associate with online and your true identity will be in the hands of the government.
So the message here is that crypto will thrive while people want to be associated with it. The day it drops out of the list of 100 things to do before you die is the day your crypto wallet has nothing but doughnuts.
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