risk and uncertainty

risk and uncertainty

a situation of potential LOSS of an individual's or firm's ASSETS and INVESTMENT resulting from the fact that they are operating in an uncertain economic environment. Some risks are insurable (for example, the risk of fire or theft of the firm's stock), but not the firm's ability to survive and prosper. The firm itself must assume the risks of the market place: if it cannot sell its products it will go bankrupt; if it is successful it will make profits. Thus, risk-taking is to be viewed as an integral part of the process of supplying GOODS and SERVICES and in innovating new products. PROFITS, in part, are a reward for successful risk-taking.

Since managers do not know for certain what the future holds, they are forced to formulate EXPECTATIONS or to guess what the most likely outcome of any decision will be, effectively assigning a statistical PROBABILITY to the likelihood of future events occurring. All such estimates of the likelihood of future events occurring must, by their very nature, be subjective, although some estimates are likely to be better than others, depending upon the amount of information available. Where large amounts of information are available upon which to base estimates of likelihood, so that accurate statistical probabilities can be formulated, we may talk of risk rather than uncertainty. For example, an insurance company dealing with fire insurance policies and claims for large numbers of manufacturers will be able to compile detailed statistics about numbers of fires and the amount of damage done by each, and can use this information to predict the likelihood of a business experiencing a fire. This detailed statistical information allows the insurance company to charge manufacturers premiums for indemnifying them against fire losses and to make a profit by so doing. By contrast, a single manufacturer would find it very difficult to predict the likelihood of his premises being damaged by fire and the amount of damage, since such an event would tend to be a unique experience for him.

Faced with a possibility of fire, the manufacturer can either choose to bear the risk of losses resulting from a serious fire or can avoid the risk of fire damage by paying an insurance company a premium to bear the risk. Again, the manufacturer can take the risk that the prices of its main raw materials will be much higher next year, or it can contract now through a commodity FUTURES MARKET to buy raw materials’ supplies for future delivery at a fixed price.

Uncertainty, unlike risk, arises from changes that are difficult to predict or from events the likelihood of which cannot be accurately estimated. Unfortunately, many management decisions fall into this category since they are rarely repetitive and there is little past data available to act as a guide to the future. Such market uncertainty as to the likelihood and extent of losses that might arise in launching a new product can be gauged by managers only through combining the limited data that is available with their own judgement and experience.

Managers can improve upon their subjective estimates about the future by collecting information from forecasts, market research feasibility studies, etc., but they need to balance the cost of collecting such information against its value in improving decisions. Where information costs are prohibitive, managers may turn to various RULES OF THUMB, like full-cost pricing, which give reasonably good (though not optimum) decisions.

The traditional THEORY OF THE FIRM envisaged a firm armed with perfect knowledge about its future costs and revenues, making pricing and output decisions on the basis of a marginal weighting of costs and revenues. This cognitive assumption of perfect knowledge is open to criticism in the light of what appears above. See ENTREPRENEUR, HEDGING, RISK PREMIUM, SCHUMPETER.

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