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Dealing with Risk and Uncertainty

The future always brings surprises. Sometimes the surprises are nice but often they are unpleasant. Many people want ways to protect themselves from the unpleasant surprises. Occasionally risk and uncertainty can be shifted to a person willing to bear them.1 While most people consider risk a problem, a speculator sees it as an opportunity. A speculator takes risks in the hope of making a profit, usually by forecasting future prices and betting his money that he is correct. If a speculator expects the price of gold to be higher in a year than it is now, he can buy gold and wait. If he is right, he will make a profit on his action, while if he is wrong, he will lose.

The development of futures markets allows anyone who wants to be a speculator to become one. In a futures market agreements to buy and sell at a future date are made with the price set when the agreement is made. There are futures markets for most major agricultural commodities. Farmers use them to fix the price of their crop long before harvest and millers and owners of feedlots use them to lock in the price they will pay for grain in the coming year. In fixing these prices with a futures contract, farmers and buyers of grain reduce the risk they take by hedging. They are able to reduce their risk because speculators are willing to take risk. Without speculators, a futures market could not function properly.

The speculator is widely regarded as someone who contributes nothing positive to the economy because he produces nothing. However, by buying when prices are low and selling when they are high, the successful speculator transfers goods from low-valued uses to high-valued ones, which is a useful task. He also smoothes price fluctuations because his purchases increases prices when they are low, and his sales when prices are high helps keep prices from going even higher.2 The benefits that speculators provide others are not part of their intentions, an example of the unintended consequences in which economists delight.

A person involved in speculation is not engaged in arbitrage, he is not a middleman, nor is he an entrepreneur. Arbitrage is buying in a market where prices are low and simultaneously selling in a different market in which they are high. There is no risk involved in pure arbitrage. Arbitrage tends to equalize prices in various markets. A middleman is part of a distribution or marketing network. Although frequently disparaged, the fact that sellers use middlemen indicates that they perform useful services. Middlemen generally try to keep risk to a minimum.

An entrepreneur deals in risk, but unlike the speculator who reduces the risk of those who do not want to bear it, the entrepreneur's risk is of his own making. The entrepreneur is the creative element in a market economy. His presence makes the system dynamic and ever-changing. Although the abstract theory of the exchange economy is a static theory emphasizing equilibrium, real-world market economies are always changing. The entrepreneur, the innovator, is a source of change. He creates new products, develops new managerial techniques, introduces new ways of producing products, and finds new resources. His role can be understood if one looks at Darwin's view of the biological world, in which a species that finds a previously unoccupied ecological niche (or that better exploits one that is already occupied) prospers. The entrepreneur is searching for unoccupied economic niches, opportunities to make a profit. The search is risky and usually ends in failure. But when it is successful, it can change the lives of all of us (just as when a new species evolves in nature, it can change the lives of all previously existing organisms). Most large corporations are the results of entrepreneurial effort, though they may no longer be performing much of the entrepreneurial function. Joseph Schumpeter, who stressed the importance of the entrepreneur more than anyone before or since, suggested that there were no permanent triumphs in the search of entrepreneurs. In a process that he called "creative destruction," he suggested that all economic niches would eventually be eliminated by further discoveries of other entrepreneurs.

Another way to deal with risk is by buying insurance.

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1Some economists, following the tradition of Frank Knight, make a distinction between risk and uncertainty. Risk exists when a probability based on past experience can be attached to an event, whereas uncertainty exists when there is no objective way to place a probability on an event. Thus, based on mortality in the past, one can say that the chance that a person who is 18 years old will die during a year is about 1 in 500. Predicting the future course of prices, on the other hand, cannot be based solely on the past, and the probabilities that people will assign to various events are more subjective and intuitive. It is difficult in practice to draw a line separating risk and uncertainty, and we will ignore the distinction.

2However, speculation can be destabilizing if everyone bases his offers on what he expects others to offer. In this case, the model of contingent behavior might apply. This sort of speculation is unlikely in markets in which annual production is large relative to inventories. It is more likely in markets in which there is little or no production, such as in rare stamps, Old Master paintings, and (to some extent) gold.

Copyright Robert Schenk