1. Human capital

2. Signalling and screening.

3. Pay differentials. Unit 13 Coping with Risk in Economic Life

The only certains are death and taxes. Nevertheless, you do not know when you are going to die or the extent of the taxes you will pay through various means. Every action we take today has a future outcome that is less than perfectly certain. It is risky. When we add to our bank account we do not know how much the money will buy when we want to use it because we are not certain how much the prices of goods will rise in the meantime. When we start a job we do not know how fast we will be promoted. When we start studying economics we have only a rough idea what is involved and even less about the purpose to which we shall put this skill once we have acquired it.

The world is a risky place. How does the presence of risk affect our actions? And how have economic institutions evolved to help us deal with risky environment in which we are forced to live?

Although there is a degree of risk in everything you do, some activities reduce it. UK citizens spend billions of pounds on insurance, which reduces the net risk they face, but they also spend over one billion pounds on legal forms of betting and gambling, an activity that has the sole purpose of artificially increasing the risk people face. Can we deduce anything about people’s general attitude to risk by examining their revealed behaviour in gambling and insurance activities?

We shall argue that people generally dislike risk and are therefore prepared to pay to have their risks reduced. We shall see that this idea allows us to explain the existence of many economic institutions that, at a price, allow those people who dislike risk most to pass on their risks to others who are more willing or more able to bear these risks.

A risky activity has two characteristics: the likely outcome (for example the likely return on an investment) and the degree of variation in all the possible outcomes. Suppose we are offered a 50 per cent chance of making 100 pounds and a 50 per cent chance of losing 100 pounds. On average you will make no money by taking such gambles. We call them fair gambles. In contrast, a 30 per cent chance of making 100 pounds and a 70 per cent chance of losing 100 pounds is an unfair gamble. On average you will lose money. With the probabilities of winning and losing reversed, the gamble would on average be profitable. We say the odds on this gamble are favourable. Now compare a gamble offering a 50 per cent chance of making or losing 100 pounds with a gamble with the same chances of winning or losing 200 pounds. Both are fair gambles, but we say the second is riskier. Depending on the outcome you will either do better or do worse, but the range of possible outcomes is greater.

Having discussed the type of gambles the market may offer, we turn now to individual tastes. Economists classify individual attitudes under three headings: risk-averse, risk-neutral, and risk-loving. The crucial question is whether or not the individual would accept a fair gamble. A risk-neutral person pays no attention to the degree of dispersion of possible outcomes, betting if and only if the odds on a monetary profit are favourable. Although any individual bet may turn out to be a loser, and there may even be quite a long string of unlucky losing bets, a risk-neutral person is interested only in whether the odds will yield a profit on average.

A risk-averse person will refuse a fair gamble. This does not mean he or she will never bet. If the odds are sufficiently favourable the probable monetary profit will overcome the inherent dislike of risk. But the more risk-averse the individual, the more favourable must the odds be before that individual will take the bet. In contrast, a risk-lover will bet even when a strict mathematical calculation reveals that the odds are unfavourable. The more risk-loving the individual, the more favourable must the odds be before the individual will decline the bet.

Some people play poker for high stakes because they know that by superior card play and psychology they can turn the odds in their favour. People with perfect memories have the odds very slightly in their favour when they play blackjack in a casino. Perhaps such gamblers are risk-lovers, or perhaps they merely reckon that the odds are sufficiently favourable no offset their relatively low degree of risk aversion. But we all know the inveterate gambler who will bet on almost anything, even when the odds are clearly unfavourable. Such people are definitely risk-lovers.

Insurance is the opposite of gambling. Suppose you own a 50000 house and there is a 10 per cent chance it will burn down by accident. Thus you have a 90 per cent chance of continuing to have 50000 pounds but a 10 per cent chance of having nothing. Our risky world is forcing you to take this bet. The average outcome is that you will end up with 45000 pounds which is 90 per cent of 50000 plus 10 per cent of nothing.

An insurance company offers to insure the full value of your house for a premium of 10000 pounds. Whether or not your house burns down, you pay the insurance company the 10000 premium, but they pay you 50000 pounds if it burns down. Whether or not your house burns down, you will end up with 40000 pounds. You are worse off by the 10000 premium, but you are then have a 50000 house or the equivalent in cash.

Would you insure? The insurance company is offering you unfavourable odds, which of course is how they make their money. If you do nothing the average outcome is 45000 pounds but the actual outcome could be 50000 or zero.. Insuring guarantees you 40000 pounds either way. A risk-neutral person would decline the insurance company’s offer. The straight mathematical calculation in monetary terms says it is on the average better to stand the risk of a fire. The risk-lover will also decline. Not only is the insurance company offering bad odds, there is also the added enjoyment of standing the risk. But a person who is sufficiently risk-averse will accept the offer, happy to give up 5000 pounds on average to avoid the possibility of catastrophe.

Decisions about gambling or insurance depend on two distinct considerations. First, there is the pleasure or pain from the risk itself. The thrill of the occasional flutter on the Grand National resembles the pleasure of seeing a good film. It has a component of pure entertainment. For other people the stress of not knowing the outcome is painful. Occasional gambling for the sheer fun of it is a legitimate form of consumption for people who enjoy it, and the standard model of consumer choice suggests that people will be prepared to pay for this modest form of entertainment. A roulette wheel does not quite offer fair odds. Yet many of us would play roulette on our birthday and regard the slightly unfavourable odds as the implicit price of our fun.

Such leisure activities form only a trivial part of the risk that we face in our everyday lives. This approach is not helpful in thinking about the risk of our house burning down or the risk a firm takes in deciding whether or not to build a new factory. It is not the spectacle that counts but the fact that different outcomes will have different implications for the financial well-being of the household or the firm. Except for the occasional small gamble for pure entertainment, people should generally be risk-averse. They should refuse fair money gambles because they are not fair utility gambles. Risk-averse individuals will devote resources to finding ways to reduce risk. As the booming insurance industry confirms, people will be prepared to pay to get out of some risks that our environment would otherwise force them to bear. Individuals who take over or bear the risk will have to be rewarded for doing so. Many economic activities consist of the more risk-averse bribing the less risk-averse to take over the risk.

We begin with a simple example of home-made insurance. A farmer and an actress have risky incomes which fluctuate from month to month. But these risks are independent. Whether or not the farmer has a good month is completely unconnected with whether or not the actress has a good month. Let’s see what happens if the two get together to pool their incomes and their risks. Suppose they share out their total incomes in proportion to their average earnings over the past few years. If they have a good month or both have a bad month the pooling arrangement makes no difference. They each get what they would have got on their own. But in case of success of one partner it offsets the failure of the other. Together they have a more stable income than they would have as individuals. If the farmer and the actress are risk-averse, they can gain by pooling their risky incomes. Pooling of independent risks is the key to the insurance business.

Risk-pooling works only when the risk can be spread over a large number of individuals, each of whose risks are essentially independent of the risks faced by all other individuals. Risk-pooling will not work when all the individuals face the same risk. This explains why many insurance companies will not provide insurance against what they call ‘acts of god’ — floods, earthquakes, epidemics. Such disasters are no more natural or unnatural than a heart attack. But earthquakes will affect large numbers of the insurance company’s clients if they happen at all. Their risk cannot be reduced by pooling.

Risk-pooling works by aggregating independent risks to make the aggregation more certain. But there is another way to reduce the cost of risk-bearing. This second method is known as risk-sharing, and the most famous example is the Lloyd’s insurance market in London. Risk-sharing is necessary when it has proved impossible to reduce the risk by pooling. Lloyd’s offer insurance on earthquakes in California, which would hit many of their clients, and one-off deals such as insurance of a film star’s legs.

Risk-sharing works by reducing the stake. You go to Lloyd’s to insure the US space shuttle launch for 20 billion pounds. That is a big risk. Only part of this risk can be pooled as part of a larger portfolio of risks. It is too big for anyone to take on at a reasonable premium.

The Lloyd’s market in London is a big room with hundreds of ‘syndicates’, each a group of 20 or so individuals who have each put up 100000 pounds. Each syndicate will take perhaps 1 per cent of the 20 billion pound deal and then resell some of the risk to yet other people in the insurance industry. By the time the deal has been subdivided and subdivided again, each syndicate or insurance company is holding only a tiny share of the total. And each syndicate risk is further subdivided among its 20 members. The risk has been shared out until each individual’s stake has been so reduced that there is only a small difference between the marginal utility in the event of a gain and the marginal loss of utility in the event of a disaster. It now requires only a small premium to cover this risk, and the whole package can be sold to the client at a premium that is low enough to attract the business.

By pooling and sharing risks, insurance allows individuals to deal with many risks at affordable premiums. But there are two interesting and complicating factors which further inhibit the operation of insurance markets, tending to reduce the extent to which individuals can use insurance to buy their way out of risky situations.

You can be insured against theft, against fire. You can insure your property only up to a certain percentage of its replacement cost. Insurance company will take a large part of the risk, but you will still be worse off if the nasty thing happens. The company is providing you with an incentive to take care and hold down the chances of the nasty thing happening. On average, they have to pay out less frequently and they can charge you lower premia.

If the fact of insuring increases the likelihood of the occurrence of the thing you wish to insure against, it is the problem of moral hazard. This problem makes it harder to get insurance and more expensive when you do get it.

The portfolio of a financial investor is the collection of financial and real assets — bank deposits, Treasury bills, government bonds, ordinary shares of industrial companies, gold, works of art — in which the financial investor’s wealth is held. How does a risk-averse investor select which portfolio or wealth composition to hold?

Instead of the choice between two different goods, we now focus on the choice between the average or expected return on the portfolio and risk that the portfolio embodies. Bank deposits are a relatively safe asset. The investor has a relatively good idea of the rate of return on bank deposits. The other asset is industrial shares, which are much riskier since their return is more variable.

The investor has a given wealth to invest. If all wealth is put into bank deposits the whole portfolio will earn the return on bank deposit and this will be relatively riskless. The higher the fraction of the portfolio held in industrial shares, the more closely the return on the whole portfolio resembles the return on shares and the riskier it becomes. A superior strategy is to diversify the portfolio. Diversification means not putting all your eggs into one basket. The metaphor belongs to Professor James Tobin of Yale who received the Nobel Prize for economics in 1981 for, among other things, his work on portfolio choice. Reporters asked him to summarize as simply as he could what his work was about. He replied that it showed that it was not wise to put all eggs in one basket. Of course Tobin’s work went well beyond the simple slogan. It showed precisely what trade-offs were involved in making portfolio choices and what portfolios the consumer would end up choosing. Diversification reduces the risk by pooling it without altering the average rate of return. It offers you a better deal.

Risk is a central characteristic of economic life. Every topic could be extended to include uncertainty. Although individual applications differ, two features recur: individuals try to find arrangements to reduce risk, and those who take over the risk-bearing have to be compensated for so doing.

Since people are risk-averse, we expect people with risky jobs to earn more on average than people whose jobs are safe. University academics earn relatively low wages in the UK because many of them have secure jobs, unlike industrial managers who may find themselves out of a job if their company has a bad spell.

At a broad level, profits are often seen as a reward given to entrepreneurs, individuals who set up and run firms, for taking big risks. The average person who starts a business works long hours for small rewards initially. In the early stages there is the continual threat of failure, and many small firms never get off the ground. The possibility of becoming a millionaire is the carrot that is required to persuade people to embark on this risky activity.

Notes

1. the only certainties are death and taxes — неотвратимы только смерть и налоги;

2. has a future outcome — имеет последствия в будущем;

3. by examining their revealed behaviour — посмотрев, как они ведут себя;

4. at a price — за определенную плату;

5. the odds on this gamble — шансы на выигрыш в этом случае;

6. inveterate gambler — заядлый игрок;

7. will have different implications for the financial well-being of the household or the firm — по-разному отразятся на благополучии семьи или фирмы;

8. the problem of moral hazard — проблема морального вреда;

9. to embark on this risky activity — пуститься в это рискованное предприятие.