May 14, 2021
May 14, 2021

Price elasticity of demand and favourite-longshot bias

What is price elasticity of demand?

Betting and airlines

Price elasticity of demand and favourite-longshot bias

Favourite-longshot bias is a much-discussed phenomenon within betting markets. This article explores whether the differences in demand for betting odds shown by different groups of bettors could be a contributor to the bias.

What is price elasticity of demand?

Price elasticity of demand measures the change in consumption of a product relative to a change in price. The more elastic the demand is, the greater the change in the quantity of a product demanded with a movement in price.

For example, for a product with elastic demand – e.g. bread – an increase in price would cause a steep fall in the amount of the product purchased. For a product with inelastic demand (the commonly used example is petrol), a similar increase in price would cause a much smaller fall in the quantity of the good demanded.

This makes sense on an intuitive level but what could the concept possibly have to do with betting?

Price discrimination: Favourites, longshots, and airlines

Favourite-longshot bias is a much-discussed topic within the betting world. It has been found that the majority of the bookmaker’s margin is placed on the longshot.

It has been inferred that part of this phenomenon is caused by more casual recreational bettors who will bet on the longshot in a given market regardless of price. Meanwhile, other more price-sensitive types of bettors tend to be looking for value on the side of the favourite.

This behaviour is explained by demand elasticity.

A similar business model, with two different groups of customers, can be found in the airline industry. Airlines attempt to maximise revenue by selling tickets at different prices to their primary sets of customers.

Recreational travellers are very price-sensitive. If plane tickets are too expensive they will opt to fly on a different date, fly to a different destination, fly with a different carrier or simply not fly at all. For this group of customers, airline tickets are a very elastically demanded product.

Conversely, an airline’s other main customer group behaves very differently. For business travellers, time savings are generally preferred over optimising for cheap air travel. They book at short notice for fixed time periods (events, conferences, etc.) and prefer to fly at convenient times on convenient dates regardless of cost. This is an example of very inelastic demand. A change in the price of a flight is unlikely to significantly alter this customer’s behaviour.

In order to maximise revenue from the two sets of customers airlines have found a nice solution. They charge a cheaper price the earlier you book your ticket. The customers with the most elastic demand curve will book early since they can be flexible on dates.

As seats are sold and the date of the flight approaches the airline increases pricing. Business travellers who book at short notice pay a premium for the ability to select their ideal time and date at short notice. Their demand curve is inelastic so an increase in price is unlikely to alter their behaviour.

The airline essentially splits their market into two. Market A is the recreational traveller and market B is the business traveller.

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When it comes to favourite-longshot bias it is possible that betting companies are behaving in a similar way.

In this case, Market A (the recreational travellers in the airline example) would be the more value-oriented bettors. Like the recreational travellers, this type of bettor is very price-sensitive. They will bet on the best odds available regardless of bookmaker and if they see no value on offer they can simply choose not to bet.

Market B (the airline’s business travellers) are the much less price-sensitive recreational bettors. They will bet where it is most convenient for them to bet, possibly attracted by factors such as the ease of use of a bookmaker’s website, and will generally choose to bet regardless of the odds on offer elsewhere.

For such customers, bookmakers are perfect substitutes for each other in an even stronger way than airlines are perfect substitutes for the recreational traveller (since airlines arguably differ more strongly on service).

If the bookmaker wishes to maximise its revenue, then the challenge is quite similar to that of airlines. The bookmaker will want both market segments to bet on an event where possible. In the same way that Market B subsidises Market A’s airline tickets, it is possible the recreational bettors fund a lower margin for the more price-sensitive customers.

When favourite-longshot bias is present in a market, it is possible that its existence is due to bookmaker’s offering odds similar to the way in which airlines maximise revenue from ticket sales.

If the bookmaker is indeed pricing in such a way, this suggests the recreational bettors will generally favour the longshot regardless of price whilst a lower margin is offered on the favourite to entice value bettors.

Unlimited supply and information flows: Why bookmaker’s limit customers

One key difference between the products offered by airlines and bookmakers is that the supply offered by the airline is fixed. They can only sell as many tickets as there are seats on the plane. Bookmakers in contrast can offer limitless supply. As long as there is a demand for a market they can take as many bets as they see fit to.

Equally, the bookmaker’s most price-sensitive customers will only bet if they expect to make a profit for themselves at the expense of the bookmaker.

The airlines may take a loss on some of their price-sensitive passengers in order to fill a plane. After all, some revenue is better than the loss taken on an empty seat. For the bookmaker, if the Market B customers can accurately calculate prices to the extent that they can consistently make a profit, be that through arbitrage or value betting, the bookmaker will make a loss from the customer with seemingly no benefit to the bookmaker himself.

The betting market would still function with participation from the less price-sensitive customers regardless of whether the savviest price-sensitive customers take part. In contrast, any of the loss-making seats on an areoplane still contribute towards the cost of putting on the flight. Certainly when compared to the alternative of empty seats.

This is why bookmakers will generally limit or ban the sharpest of the customers with elastic demand curves. They are a net loss and, since the bookmaker can differentiate between the Market A and the Market B customers, it is simple enough just to place restrictions on Market B customers that are a threat to the bookmaker’s profit. They bring nothing to the table from the bookmaker’s point of view.

Pinnacle, however, do not ban or limit these bettors. For Pinnacle, the information conveyed by the bets of the highly price-sensitive customers is a payment in itself. It allows for more accurate line setting.

This allows more accurate odds setting to take more revenue from Market A customers. It also means that they can maximise revenue from less-skilled Market B bettors. As Pinnacle is often one of few options for such bettors and there are few-to-none perfect substitutes available, they can achieve a very high volume from this market segment.

Volatility: Why would sharp bettors prefer short odds?

One question still to be answered is: why would the sharper Market B bettors prefer shorter odds to longshots?

One possibility is that the increased volatility caused by betting on such unlikely events makes measuring success very difficult. With events that occur more often, it is easier to achieve a sample size significant enough to demonstrate long-term profitability.

In the same way, a bookmaker may be wary of mispricing a longshot since the potential payout on an error could be very large. If this is the case, then it may not be that the sharper bettors prefer favourites, they are simply being herded towards the more probable option by conservative bookmaker pricing.

Another possible contributing factor is that it may also be the case that Market A bettors simply enjoy the thrill of high-odds bets. Since these bettors are betting primarily for fun as opposed to profitability (whether they are aware of this themselves is probably moot), then this makes some sense.

After all, turning 100 euro into 1,000 does sound more fun than turning 100 euro into 110 from purely an entertainment point of view.

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