Provide economic explanations of the following puzzling behaviors.

Question

(i) Many risk-averse people choose to buy lottery tickets, even when the lottery does not offer fair odds.
(ii) Many furniture stores, instead of simply lowering their prices, offer buyers 6 months interest-free with no money down and no monthly payment.
(iii) Although they are not required to do so, plumbers, auto mechanics, and other repair services give customers a 30-day warranty on the parts and labor.

Answer 1

(i) Lotteries are often run in the form of games, where the person chooses numbers or scratches a ticket, and a person receives some entertainment value in playing the game. Furthermore, people get value from fantasizing about their lives if they would win the lottery-these dreams would be less valuable if they had absolutely no chance of coming true. These additional benefits that the person receives from the lottery likely offset the cost incurred from placing a very small bet at unfair odds.
(ii) Furniture stores may be using free financing as a means to price discriminate. Many people who wish to buy new furniture have recently purchased new homes which require substantial down payments. The "free financing" group likely has more elastic demand than the "pay cash" group. The free financing both implements third-degree price discrimination (the free financing gives a discount to the group with the more elastic demand) and provides information to help the store practice first-degree price discrimination (the store will try to extract a higher price from the cash buyer than from the free financier).
(iii) Warranties may be an attempt to address a principal-agent problem in which the customer is the principal and the repair service is the agent. If the customer does not have the knowledge to do the repair, the repair service's behavior will be largely unobservable to the customer. In such cases, the Coase Theorem shows that liability should be assigned to the agent when economic efficiency is the goal. Warranties are a means of assigning liability to the agent (i.e., the repair service).