Knowledge And Decisions

While risk may be easy to understand by considering formal organizations and transactions designed primarily to deal with risk, its effects are pervasive far beyond such situations. Anyone who buys an automobile knows (or discovers) that he is not really buying transportation, but is in fact buying a given probability of transportation on given occasions. If he keeps the car long enough, there will be occasions when he has to walk or take the bus or get a ride with a friend. He may do this voluntarily, as an investment, by leaving his car in the shop for regular maintenance, or he may forego that investment for the present benefits of constant use of the automobile, and involuntarily walk, take a bus, etc., at a later time when the car breaks down as a result of lack of maintenance. Cars which are very similar in the quality of ride, convenience of operation, or aesthetic considerations, may sell for very different prices if they differ substantially in their respective probabilities of continuous service — that is, if they differ in the frequency of breakdowns or the amount of maintenance required. These may be differences in brands of cars or differences in the same car purchased new and used. In either case, cars’ price differences need not reflect transportation differences, but may reflect simply risk differences. As in the case of other kinds of risks, however objective the probabilities may be, the costs of risk are highly diverse with respect to individual situations and subjective preferences. An auto mechanic or someone else who is handy with tools may find the cheapness of a particular car more than compensates its special troubles, while a heart surgeon with no understanding of engines may find a car that won’t start an intolerable problem when he has to rush to treat someone in the intensive care ward.

The fact that costs differ vastly with respect to individual knowledge and preferences creates an opportunity for people who specialize in bearing particular kinds of risks. A farmer may have considerable knowledge of how to grow a particular crop, but little knowledge of the economic data or complex principles which cause the prospective price that he can expect for his harvest to vary by large amounts as of planting time. Someone else who has specialized in studying the economic facts and principles may have a much narrower range of expectations of future prices for that crop, even if he could not actually grow the crop himself if his life depended on it. Either individual could directly acquire the knowledge that the other possesses by investing the time needed for both the theoretical understanding and the practical experience to apply it. A less costly alternative may be to transact with one another on the basis of their existing knowledge. The farmer can reduce his risk at the cost of selling his crop during the planting season for somewhat less than the average of his range of expectations of prices at harvest time. If he thinks the price of his produce is going to range somewhere between sixty cents apiece and a dollar apiece, he might consider eighty cents apiece as his best guess, but accept seventy-eight cents apiece as a guaranteed price in advance — in effect paying someone else two cents apiece to take the risk off his hands. The buyer may accept this if he has either a more optimistic estimate, or reason to have much more confidence than the farmer in the same estimate of eighty cents apiece, or merely stronger nerves.

Buying for a guaranteed price and selling at whatever price later emerges in the market is a way of earning a residual claim to the difference. This residual claim may be a positive amount or a negative amount, as many a bankrupt speculator has learned. People who are not pure speculators may nevertheless engage in economic speculation as a part of their normal activities. A farmer who plants in the spring without any guaranteed price for his harvest the following fall is working as a speculator as well as a farmer, whether he thinks of it in those terms or not. A student who chooses to study for a particular profession is also speculating on the state of that profession in future years, as well as on what his own values will be in future years, since changing values may make him dissatisfied even if the profession itself is exactly as he foresaw it. Perhaps the greatest speculation of all is bringing a child into the world, where he may become the pride and joy of your life or cloud or destroy whatever happiness you may find from other sources.

RESIDUAL CLAIMS