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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. They are willing to pay for protection against
risk and uncertainty.1
Where some people consider risk a problem, others see it
as an opportunity. A speculator is one who takes
risks in the hope of making a profit, usually by trying to
forecast 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 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 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 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 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. Though frequently disparaged, the fact that sellers
are willing to use middlemen indicates that they do perform
a useful service. Middlemen generally try to keep risk to a
minimum.
The 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 with insurance.
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
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