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Risk, Uncertainty, and Profit; Knight, Frank H.
50 paragraphs found.
Preface
Note:
Article, "Profit," in Coquelin and Guillaumin's Dictionnaire de l'économie politique, Paris, 1852. It is true that in another work (Traité d'économie politique, 2d ed., 1867) Courcelle was not so explicit, and also that in the same article he says that profit depends on the intelligence of the entrepreneur and the favorable or unfavorable conditions under which he works. This hesitation may explain Kleinwächter's classifying him with the followers of Say and adherents of the wages theory. (See Das Einkommen and seine Verteilung, p. 278.) It seems more probable, however, that Courcelle glimpsed the fact (which Kleinwächter did not) that the assumption of a "risk" of error in one's own judgment, inherent in the making of a responsible decision, is a phenomenon of a different character from the assumption of "risk" in the insurance sense. We shall build largely upon this distinction later.
Note:
These national designations of the two schools hold closely. The only notable exceptions (aside from Courcelle) are on the one side, Rossi, a French (naturalized Italian) writer, who strongly espoused the capitalistic or English view, and on the other Samuel Read who, while agreeing with the current English treatment in terminology, broke with it in substance and agreed with Say and his followers. Read insisted on identifying "profit" with the return to capital, or interest, and treating the distinctive income of the entrepreneur as a wage. He also emphasized the "compensation for risk" element in his "profit" (really interest), but thought it due to no determinate causes and "outside the pale of science." This last phrase shows at least an insight into the unique character of this sort of risk, since the assertion would certainly not have been made of an insurance premium. See his Political Economy, Edinburgh, 1829, pp. 263 and 269, note.
Note:
The Economic Theory of Risk and Insurance, Columbia University Studies in Political Science, vol. XIV, no. 2.
Note:
Risk is defined as "the objective correlative of the subjective uncertainty" (p. 29), which varies with the mathematical chance of loss in such a way as to be at a maximum when the chances for and against the event are exactly even. But it is still to be regarded as a known quantity, since the mathematical chance is assumed to be known. Willett nowhere makes an explicit statement on this point, as Hawley does (see quotation in text on p. 42 above), but his discussion clearly shows that it is viewed as a known quantity. He takes his illustrations from games of chance or from the field of insurance, speaks of the influence of "a given degree of risk" (p. 65) on investors, etc. He does recognize the fact that the degree of risk is not always known in fact, and discusses methods of estimating the degree of risk; but (pp. 66 and 76) he expressly eliminates from the discussion the consequences of error in estimating the true value of the risk.
Pt.I,Ch.I
Note:
Article, "Profit," in Coquelin and Guillaumin's Dictionnaire de l'économie politique, Paris, 1852. It is true that in another work (Traité d'économie politique, 2d ed., 1867) Courcelle was not so explicit, and also that in the same article he says that profit depends on the intelligence of the entrepreneur and the favorable or unfavorable conditions under which he works. This hesitation may explain Kleinwächter's classifying him with the followers of Say and adherents of the wages theory. (See Das Einkommen and seine Verteilung, p. 278.) It seems more probable, however, that Courcelle glimpsed the fact (which Kleinwächter did not) that the assumption of a "risk" of error in one's own judgment, inherent in the making of a responsible decision, is a phenomenon of a different character from the assumption of "risk" in the insurance sense. We shall build largely upon this distinction later.
Note:
These national designations of the two schools hold closely. The only notable exceptions (aside from Courcelle) are on the one side, Rossi, a French (naturalized Italian) writer, who strongly espoused the capitalistic or English view, and on the other Samuel Read who, while agreeing with the current English treatment in terminology, broke with it in substance and agreed with Say and his followers. Read insisted on identifying "profit" with the return to capital, or interest, and treating the distinctive income of the entrepreneur as a wage. He also emphasized the "compensation for risk" element in his "profit" (really interest), but thought it due to no determinate causes and "outside the pale of science." This last phrase shows at least an insight into the unique character of this sort of risk, since the assertion would certainly not have been made of an insurance premium. See his Political Economy, Edinburgh, 1829, pp. 263 and 269, note.
Note:
The Economic Theory of Risk and Insurance, Columbia University Studies in Political Science, vol. XIV, no. 2.
Note:
Risk is defined as "the objective correlative of the subjective uncertainty" (p. 29), which varies with the mathematical chance of loss in such a way as to be at a maximum when the chances for and against the event are exactly even. But it is still to be regarded as a known quantity, since the mathematical chance is assumed to be known. Willett nowhere makes an explicit statement on this point, as Hawley does (see quotation in text on p. 42 above), but his discussion clearly shows that it is viewed as a known quantity. He takes his illustrations from games of chance or from the field of insurance, speaks of the influence of "a given degree of risk" (p. 65) on investors, etc. He does recognize the fact that the degree of risk is not always known in fact, and discusses methods of estimating the degree of risk; but (pp. 66 and 76) he expressly eliminates from the discussion the consequences of error in estimating the true value of the risk.
Pt.I,Ch.II
I.II.8

Still another group, of more importance for our purposes, contended that profit should be recognized as a unique form of income, not susceptible of reduction to remuneration for either capital or labor. This position was taken in a somewhat timid way by Hufeland *19 and more definitely by Riedel, *20 but its most notable advocates were Thünen and v. Mangoldt. Thünen's great work, "Der Isolirte Staat," *21 defines profit as what is left after (a) interest, (b) insurance, and (c) wages of management, are met. This residuum consists of two parts: (1) payment for certain risks, especially changes in values and the chance of failure of the whole enterprise, which cannot be insured against, and (2) the extra productivity of the manager's labor due to the fact that he is working for himself, his "sleepless nights" when he is planning for the business. Thünen called these elements respectively Industriebelohnung and Unternehmergewinn, and their sum Gewerbsprofit.

I.II.9

A most careful and exhaustive analysis of profit is contained in the monograph of H. v. Mangoldt, already referred to. Proceeding on the basis of an elaborate classification of the forms of industrial organization and a discussion of the economic advantages of the entrepreneur form, this writer finds in the income of the business enterpriser a complex group of unique elements. He divides it first into three parts: (1) a premium on those risks which are of such a nature that he cannot shift them by insurance; (2) entrepreneur interest and wages, including only payments for special forms of capital or productive effort which do not admit of exploitation by any other than their owner; (3) entrepreneur rents. These last again fall into four subdivisions: (a) capital rents, (b) wage rents, (c) large enterprise rent, and (d) "entrepreneur rent in the narrower sense." They are all due to the limitation of special capacities or characteristics (the last to special combinations of such) and are called "premiums on scarcity" (Seltenheits prämeien). This is, of course, a question-begging term (though many writers have used it) since all incomes depend in the same way on the limitation of the agencies to which they are imputed. It would seem that every imaginable source of income is included in this minute and subtle classification.

I.II.30

Except for one or two passing references, Professor Clark does not take up the subject of risk in the treatise from which we have quoted. In a short article on "Insurance and Profits" *45 (written in refutation of Mr. Hawley) he takes the position that risk-taking gives rise to a special category of income, but that it accrues to the capitalist, and cannot go to the entrepreneur, as such. How he would treat this income, what relation it would bear to interest, he does not tell us. But it is no part of profit, which is defined as "the excess of the price of goods over their cost." *46 "It goes without saying that the hazard of business falls on the capitalist. The entrepreneur, as such, is empty-handed. No man can carry risk who has nothing to lose." *47 In his later work, the "Essentials of Economic Theory," the subject of risk again receives scant attention. *48 Risks are simply ruled out of the discussion, since "the greater part of them arise from dynamic causes," and the "unavoidable remainder" of static risk can be taken care of by setting aside "a small percentage of the annual gains [of each establishment, which]... will make good these losses as they occur and leave the businesses in a condition in which they can yield as a steady return to owners of stock, to lenders of... capital, and to laborers all of their real product."

I.II.37

It is admitted that the entrepreneur may get rid of risk in some cases for a fixed cost, by means of insurance. But by the act of insurance the business man abdicates so much of his entrepreneurship, "for it is manifest that an entrepreneur who should eliminate all his risks by means of insurance would have left no income at all which was not resolvable into wages of management and monopoly gains" (i.e., no profit). *58 To the extent to which the business man insures, he restricts the exercise of his peculiar function, but the risk is merely transferred to the insurer, who by accepting it becomes himself an enterpriser and the recipient of an unpredetermined residue or profit." The reward of an insurer is not the premium he receives, but the difference between that premium and the loss he eventually suffers." *59

I.II.41

Mr. Hawley does not regard the term "risk" as calling for special definition, but it is clear that, like the other writers, he treats it as a known quantity; he says this much explicitly. *67 He and his opponents alike have failed to appreciate the fundamental difference between a determinate uncertainty or risk and an indeterminate, unmeasurable one. The only practical bearing of the question as to whether the value of the risk is known which is recognized by Hawley is to determine whether it is likely to be insured, which is to say merely who will get the "profit" for assuming it; even this point is not very explicitly made. Now a little consideration will show that there can be no considerable "irksomeness" attached to exposure to an insurable risk, for if there is it will be insured; hence there can be no peculiar income arising out of this alleged indisposition. If risk were exclusively of the nature of a known chance or mathematical probability, there could be no reward of risk-taking; the fact of risk could exert no considerable influence on the distribution of income in any way. For if the actuarial chance of gain or loss in any transaction is ascertainable, either by calculation a priori or by the application of statistical methods to past experience, the burden of bearing the risk can be avoided by the payment of a small fixed cost limited to the administrative expense of providing insurance.

I.II.42

The fact is that while a single situation involving a known risk may be regarded as "uncertain," this uncertainty is easily converted into effective certainty; for in a considerable number of such cases the results become predictable in accordance with the laws of chance, and the error in such prediction approaches zero as the number of cases is increased. Hence it is simply a matter of an elementary development of business organization to combine a sufficient number of cases to reduce the uncertainty to any desired limits. This is, of course, what is accomplished by the institution of insurance.

I.II.43

It is true that the person subject to such a risk may voluntarily choose not to insure, but it is hard to distinguish such a course from deliberate gambling, and economists have not felt constrained to recognize gambling gains in general as a special income category in the theory of distribution. If it is objected that practical difficulties may prevent insurance even where the risk is determinate, the reply is that insurance, in the technical sense, is only one method of applying the same principle. We shall show at length in our general discussion of risk and uncertainty that if the risk is measurable, but the "moral factor" or some other consideration makes ordinary insurance inapplicable, some other method of securing the same result will be developed and employed. When the technique of business organization has reached a fairly high stage of development a known degree of uncertainty is practically no uncertainty at all, for such risks will be borne in groups large enough to reduce the uncertainty to substantially negligible proportions.

Note:
Article, "Profit," in Coquelin and Guillaumin's Dictionnaire de l'économie politique, Paris, 1852. It is true that in another work (Traité d'économie politique, 2d ed., 1867) Courcelle was not so explicit, and also that in the same article he says that profit depends on the intelligence of the entrepreneur and the favorable or unfavorable conditions under which he works. This hesitation may explain Kleinwächter's classifying him with the followers of Say and adherents of the wages theory. (See Das Einkommen and seine Verteilung, p. 278.) It seems more probable, however, that Courcelle glimpsed the fact (which Kleinwächter did not) that the assumption of a "risk" of error in one's own judgment, inherent in the making of a responsible decision, is a phenomenon of a different character from the assumption of "risk" in the insurance sense. We shall build largely upon this distinction later.
Note:
These national designations of the two schools hold closely. The only notable exceptions (aside from Courcelle) are on the one side, Rossi, a French (naturalized Italian) writer, who strongly espoused the capitalistic or English view, and on the other Samuel Read who, while agreeing with the current English treatment in terminology, broke with it in substance and agreed with Say and his followers. Read insisted on identifying "profit" with the return to capital, or interest, and treating the distinctive income of the entrepreneur as a wage. He also emphasized the "compensation for risk" element in his "profit" (really interest), but thought it due to no determinate causes and "outside the pale of science." This last phrase shows at least an insight into the unique character of this sort of risk, since the assertion would certainly not have been made of an insurance premium. See his Political Economy, Edinburgh, 1829, pp. 263 and 269, note.
Note:
The Economic Theory of Risk and Insurance, Columbia University Studies in Political Science, vol. XIV, no. 2.
Note:
Risk is defined as "the objective correlative of the subjective uncertainty" (p. 29), which varies with the mathematical chance of loss in such a way as to be at a maximum when the chances for and against the event are exactly even. But it is still to be regarded as a known quantity, since the mathematical chance is assumed to be known. Willett nowhere makes an explicit statement on this point, as Hawley does (see quotation in text on p. 42 above), but his discussion clearly shows that it is viewed as a known quantity. He takes his illustrations from games of chance or from the field of insurance, speaks of the influence of "a given degree of risk" (p. 65) on investors, etc. He does recognize the fact that the degree of risk is not always known in fact, and discusses methods of estimating the degree of risk; but (pp. 66 and 76) he expressly eliminates from the discussion the consequences of error in estimating the true value of the risk.
Pt.II,Ch.IV
II.IV.66

Under these conditions a person could arrange, by the purchase and sale of income property, for any desired distribution of consumption over any specified period, or, through an appropriate life insurance organization, over the uncertain period of his life. Those wishing to postpone consumption, to secure a rising distribution of real income, would buy such property in the earlier years and gradually sell it off in the later ones. Those wishing to anticipate future production and secure a descending curve of consumption would progressively sell off their land. (Persons possessing no land could make the anticipation arrangement only in the manner described above in discussing a situation where such goods were absent.) The society as a whole cannot anticipate future production unless there is some other society from which it can borrow. It can postpone in the aggregate only as in the situation above described, through an actual accumulation of consumption goods. The process of net accumulation would again tend toward an equilibrium with current production and consumption equal, though the goal might be an indefinite distance in the future. There must at any time be an equilibration of the two sorts of motives through the discount rate established, together with, in the case just mentioned, a certain rate of net accumulation.

Note:
We must here assume it to be made absolutely dependable by insurance or otherwise.
Pt.III,Ch.VII
III.VII.23

Furthermore, even if the proportion is not approximately one hundred per cent, even if it is only half or less, the same fact may hold good. If in a certain class of cases a given outcome is not certain, nor even extremely probable, but only contingent, but if the numerical probability of its occurrence is known, conduct in relation to the situation in question may be ordered intelligently. Business operations, as already observed, illustrate the point perfectly. Thus, in the example given by von Mangoldt, the bursting of bottles does not introduce an uncertainty or hazard into the business of producing champagne; since in the operations of any producer a practically constant and known proportion of the bottles burst, it does not especially matter even whether the proportion is large or small. The loss becomes a fixed cost in the industry and is passed on to the consumer, like the outlays for labor or materials or any other. And even if a single producer does not deal with a sufficiently large number of cases of the contingency in question (in a sufficiently short period of time) to secure constancy in its effects, the same result may easily be realized, through an organization taking in a large number of producers. This, of course, is the principle of insurance, as familiarly illustrated by the chance of fire loss. No one can say whether a particular building will burn, and most building owners do not operate on a sufficient scale to reduce the loss to constancy (though some do). But as is well known, the effect of insurance is to extend this base to cover the operations of a large number of persons and convert the contingency into a fixed cost. It makes no difference in the principles whether the grouping of cases is effected through a mutual organization of the persons directly affected or through an outside commercial agency.

III.VII.26

The import of this distinction for present purposes is that the first, mathematical or a priori, type of probability is practically never met with in business, while the second is extremely common. It is difficult to think of a business "hazard" with regard to which it is in any degree possible to calculate in advance the proportion of distribution among the different possible outcomes. *8 This must be dealt with, if at all, by tabulating the results of experience. The "if at all" is an important reservation, which will be discussed presently. It is evident that a great many hazards can be reduced to a fair degree of certainty by statistical grouping—also that an equally important category cannot. We should note, however, two other facts. First, the statistical treatment never gives closely accurate quantitative results. Even in such simple cases as mechanical games of chance it would never be final, short of an infinite number of instances, as already observed. Furthermore, the fact that a priori methods are inapplicable is connected with a much greater complication in the data, which again carries with it a difficulty, in fact impossibility, of securing the same degree of homogeneity in the instances classed together. This point will have to be gone into more fully. The second fact mentioned in regard to the two methods is that the hazards or probabilities met with in business do admit of a certain small degree of theoretical treatment, supplementing the application of experience data. Thus in the case of fire risk on buildings, the fact that the cases are not really homogeneous may be offset in part by the use of judgment, if not calculation. It is possible to tell with some accuracy whether the "real risk" in a particular case is higher or lower than that of a group as a whole, and by how much. This procedure, however, must be treated with caution. It is not clear that there is an ultimate separation between the calculation of departures from a standard type and more minute classification of types. There is, however, a difference in form, and insurance companies constantly follow both practices, that of defining groups as accurately as possible and also that of modifying or adjusting the coefficient applied within a class according to special circumstances which are practically always present.

III.VII.30

Yet practically there is no danger, figuratively speaking, that any of these phenomena will ever be amenable to prediction in the individual instance. The fundamental fact underlying probability reasoning is generally assumed to be our ignorance. If it were possible to measure with absolute accuracy all the determining circumstances in the case it would seem that we should be able to predict the result in the individual instance, but it is obtrusively manifest that in many cases we cannot do this. It will certainly not be proposed in the typical insurance situations, the chance of death and of fire loss, probably not even in the case of gambling devices. The question arises whether we should draw a distinction between necessary and only factual ignorance of the data in a given case. Take the case of balls in an urn. One man knows that there are red and black balls, but is ignorant of the numbers of each; another knows that the numbers are three of the former to one of the latter. It may be argued that "to the first man" the probability of drawing a red ball is fifty-fifty, while to the second it is seventy-five to twenty-five. Or it may be contended that the probability is "really" in the latter ratio, but that the first man simply does not know it. It must be admitted that practically, if any decision as to conduct is involved, such as a wager, the first man would have to act on the supposition that the chances are equal. And if the real probability reasoning is followed out to its conclusion, it seems that there is "really" no probability at all, but certainty, if knowledge is complete. The doctrine of real probability, if it is to be valid, must, it seems, rest upon inherent unknowability in the factors, not merely the fact of ignorance. And even then we must always consult the empirical facts, for it will not do to assume out of hand that the unknown causes in a case will distribute themselves according to the law of indifference among the different instances. We seem to be driven back to a logical impasse. The postulates of knowledge generally involve the conclusion that it is really determined in the nature of things which house will burn, which man die, and which face of the thrown die will come uppermost. The logic which we actually use, however, assumes that the result is really indeterminate, that the unknowable causes actually follow a law of indifference. The phenomenal constancy of distribution to which we are forced to appeal justifies this reasoning on the whole, but clearly is not its actual basis in our thinking. Wherever we find that there is not indifference, that the results show "bias," we assume some determinable cause at work; and the results of experience on the whole justify this assumption also.

III.VII.39

The theoretical difference between the probability connected with an estimate and that involved in such phenomena as are dealt with by insurance is, however, of the greatest importance, and is clearly discernible in nearly any instance of the exercise of judgment. Take as an illustration any typical business decision. A manufacturer is considering the advisability of making a large commitment in increasing the capacity of his works. He "figures" more or less on the proposition, taking account as well as possible of the various factors more or less susceptible of measurement, but the final result is an "estimate" of the probable outcome of any proposed course of action. What is the "probability" of error (strictly, of any assigned degree of error) in the judgment? It is manifestly meaningless to speak of either calculating such a probability a priori or of determining it empirically by studying a large number of instances. The essential and outstanding fact is that the "instance" in question is so entirely unique that there are no others or not a sufficient number to make it possible to tabulate enough like it to form a basis for any inference of value about any real probability in the case we are interested in. The same obviously applies to the most of conduct and not to business decisions alone.

Note:
The problem of uncertainty and risk in economics is, of course, not new. Some reference has already been made to the literature. It has been recognized and discussed in three connections: (1) insurance; (2) speculation; and (3) entrepreneurship. For a full treatment of the last-named it is necessary to go to the German works cited in the historical portion of this study. English economics has been too exclusively occupied with long-time tendencies or with "static" economics to give adequate attention to this problem. For a very general discussion of uncertainty see, in addition to works already cited, Ross, Uncertainty as a Factor in Production, Annals, American Academy, vol. VIII, pp. 304 ff. See also Leslie, T. E. Cliffe, "The Known and the Unknown in the Economic World," Essays in Political Economy, pp. 221-42; Lavington, F., "Uncertainty in its Relation to the Rate of Interest," in Economic Journal, vol. XXII, pp. 398-409; and "The Social Interest in Speculation," ibid., vol. XXIII, pp. 36-52; Pigou, A. C., Wealth and Welfare, part V; Haynes, John, "Risk as an Economic Factor," Quarterly Journal of Economics, July, 1895.

In this superficial sketch of the theory of knowledge it has not seemed important to give extended reference to philosophic literature. It will be evident that the doctrine expounded is a functional or pragmatic view, with some reservations. By way of further "reservation" we should point out that the tone of the discussion merely results from the fact that it is the function of consciousness and knowledge in relation to conduct that we are interested in, for present purposes, and the text must not be taken as expressing any view whatever as to the ultimate nature of reality or any other philosophic position. The writer is in fact a radical empiricist in logic, which is to say, as far as theoretical reasoning is concerned, an agnostic on all questions beyond the fairly immediate facts of experience.

Pt.III,Ch.VIII
III.VIII.1

Structures and Methods for Meeting Uncertainty

Part III, Chapter VIII

To preserve the distinction which has been drawn in the last chapter between the measurable uncertainty and an unmeasurable one we may use the term "risk" to designate the former and the term "uncertainty" for the latter. The word "risk" is ordinarily used in a loose way to refer to any sort of uncertainty viewed from the standpoint of the unfavorable contingency, and the term "uncertainty" similarly with reference to the favorable outcome; we speak of the "risk" of a loss, the "uncertainty" of a gain. But if our reasoning so far is at all correct, there is a fatal ambiguity in these terms, which must be gotten rid of, and the use of the term "risk" in connection with the measurable uncertainties or probabilities of insurance gives some justification for specializing the terms as just indicated. We can also employ the terms "objective" and "subjective" probability to designate the risk and uncertainty respectively, as these expressions are already in general use with a signification akin to that proposed.

III.VIII.19

Following the order of the classification already given of methods of dealing with uncertainty, the first subject for discussion is the institutions or special phenomena arising from the tendency to deal with uncertainty by consolidation. The most obvious and best known of these devices is, of course, insurance, which has already been repeatedly used as an illustration of the principle of eliminating uncertainty by dealing with groups of cases instead of individual cases. In our discussion of the theory of uncertainty in the foregoing chapter and at other points in the study we have emphasized the radical difference between a measurable and an unmeasurable uncertainty. Now measurability depends on the possibility of assimilating a given situation to a group of similars and finding the proportions of the members of the group which may be expected to exhibit the various possible outcomes. This assimilation of cases into classes may be exceedingly accurate, and the proportions of the various outcomes may be computable on a priori grounds by the application of the theory of permutations and combinations to determine the possible groupings of equally probable alternatives; but this rarely if ever happens in a practical business situation. The classification will be of all degrees of precision, but the ascertainment of proportions must be empirical. The application of the insurance principle, converting a larger contingent loss into a smaller fixed charge, depends upon the measurement of probability on the basis of a fairly accurate grouping into classes. It is in general not enough that the insurer who takes the "risk" of a large number of cases be able to predict his aggregate losses with sufficient accuracy to quote premiums which will keep his business solvent while at the same time imposing a burden on the insurer which is not too large a fraction of his contingent loss. In addition he must be able to present a fairly plausible contention that the particular insured is contributing to the total fund out of which losses are paid as they accrue in an amount corresponding reasonably well with his real probability of loss; i.e., that he is bearing his fair share of the burden.

III.VIII.20

The difficulty of a satisfactory logical discussion of the questions we are dealing with has repeatedly been emphasized, due to the fact that distinctions of the greatest importance tend to run together through intermediate degrees and become blurred. This is conspicuously the case with the measurability of uncertainty through classification of instances. We hardly find in practice really homogeneous classifications (in the sense in which mathematical probability implies, as in the case of successive throws of a perfect die) and at the other extreme it is hard to find cases which do not admit of some possibility of assimilation into groups and hence of measurement. Indeed, the very concept of contingency seems to preclude absolute uniqueness (as for that matter there is doubtless nothing absolutely unique in the universe). For to say that a certain event is contingent or "possible" or "may happen" appears to be equivalent to saying that "such things " have been known to happen before, and the "such things" manifestly constitute a class of cases formed on some ground or other. The principal subject for investigation is thus the degree of assimilability, or the amount of homogeneity of classes securable, or, stated inversely, the degree of uniqueness of various kinds of business contingencies. Insurance deals with those which are "fairly" classifiable or show a relatively low degree of uniqueness, but the different branches of insurance show a wide range of variation in the accuracy of measurement of probability which they secure.

III.VIII.21

Before taking up various types of insurance we may note in passing a point which it is superfluous to elaborate in this connection, namely, that different forms of organization in the insurance field all operate on the same principle. It matters not at all whether the persons liable to a given contingency organize among themselves into a fraternal or mutual society or whether they separately contract with an outside party to bear their losses as they fall in. Under competitive conditions and assuming that the probabilities involved are accurately known, an outside insurer will make no clear profit and the premiums will under either system be equal to the administrative costs of carrying on the business.

III.VIII.22

The branch of insurance which is most highly developed, meaning that its contingencies are most accurately measured because its classifications are most perfect, and which is thus on the most nearly "mathematical" basis is, of course, what is called "life insurance." (In so far as it is "insurance" at all, and not a mere investment proposition, it is clear that it is insurance against "premature" loss of earning power, and not against death.) It is possible, on the basis of medical examinations, and taking into account age, sex, place of residence, occupation, and habits of life, to select "risks" which closely approximate the ideal of mechanical probability. The chance of death of two healthy individuals similarly circumstanced in the above regards seems to be about as near an objective equality, the life or death of one rather than the other about as nearly really indeterminate, as, anything in nature. To be sure, when we pass outside the relatively narrow circle of "normal" individuals, difficulties are encountered, but the extension of life insurance outside this circle has also been restricted. Some development has taken place in the insurance of sub-standard lives at higher rates, but it is limited in amount and could be characterized as exceptional. *17

III.VIII.23

The very opposite situation from life insurance is found in insurance against sickness and accident. Here an objective description and classification of cases is impossible, the business is fraught with great difficulties and susceptible of only a limited development. It is notorious that such policies cost vastly more than they should; indeed, the companies find it profitable to adopt a generous attitude in the adjustment of claims, raising the premium rates accordingly, it is needless to say. Accident compensation for workingmen, under social control, is on a somewhat better footing, but only on condition that the payments are restricted to not too large a fraction of the actual economic loss to the individual, with nothing for discomfort, pain, or inconvenience. In the whole field of personal, physical contingencies, however, there is nothing that is strictly of the nature of a "business risk," unless it be the now happily obsolescent phenomenon of commercial employers' liability insurance.

III.VIII.24

The typical application of insurance to business hazards is in the protection against loss by fire, and the theory of fire insurance rates forms an interesting contrast with the actuarial mathematics of life insurance. The latter, as we have observed, is a fairly close approximation to objective probability; it is in fact so close to this ideal that life insurance problems are worked by the formulæ derived from the binomial law, in the same way as problems in mechanical probability. Fire insurance rating is a very different proposition; only in rather recent years has any approach been made to the formation of fairly homogeneous classes of risks and the measurement of real probability in a particular case. At best there is a large field for the exercise of "judgment" even after literally thousands of classes of risks have been more or less accurately defined. *18 More important is the fact that, in consequence, insurance does not take care of the whole risk against loss by fire. On account of the "moral hazard" and practical difficulties, it is necessary to restrict the amount of insurance to the "direct loss or damage" or even to a part of that, while of course there are usually large indirect losses due to the interruption of business and dislocation of business plans which are entirely unprovided for. Thus there is a large margin of uncertainty both to insurer and insured, in consequence of the impossibility of objectively homogeneous groupings and accurate measurement of the chance of loss. Corresponding to this margin of uncertainty in the calculations there is a chance for a profit or loss to either party, in connection with the fire hazard. The probabilities in the case of fire are, of course, complicated by the fact that risks are not entirely independent. A fire once started is likely to spread and there is a tendency for losses to occur in groups. In so far, however, as fire losses in the aggregate are calculable in advance, they are or may be converted into fixed costs by every individual exposed to the possibility of loss, and in so far no profit, positive or negative, will be realized by any one on account of this uncertainty in his business.

III.VIII.25

The principle of insurance has also been utilized to provide against a great variety of business hazards other than fire—the loss of ships and cargoes at sea, destruction of crops by storms, theft and burglary, embezzlement by employees (indirectly through bonding, the employee doing the insuring), payment of damages to injured employees, excessive losses through credit extension, etc. The unusual forms of policies issued by some of the Lloyd's underwriters have attained a certain amount of publicity as popular curiosities. These various types of contingencies offer widely divergent possibilities for "scientific" rate-making, from something like the statistical certainty of life insurance at one extreme to almost pure guesswork at the other, as when Lloyd's insures the business interests concerned that a royal coronation will take place as scheduled, or guarantees the weather in some place having no records to base calculations upon. Even in these extreme cases, however, there is a certain vague grouping of cases on the basis of intuition or judgment; only in this way can we imagine any estimate of a probability being arrived at.

III.VIII.26

It is therefore seen that the insurance principle can be applied even in the almost complete absence of scientific data for the computation of rates. If the estimates are conservative and competent, it turns out that the premiums received for insuring the most unique contingencies cover the losses; that there is an offsetting of losses and gains from one venture to another, even when there is no discoverable kinship among the ventures themselves. The point seems to be, as already noticed, that the mere fact that judgment is being exercised in regard to the situations forms a fairly valid basis for assimilating them into groups. Various instances of the exercise of (fairly competent) judgment even in regard to the most heterogeneous problems, show a tendency to approach a constancy and predictability of result when aggregated into groups.

III.VIII.27

The fact which limits the application of the insurance principle to business risks generally is not therefore their inherent uniqueness alone, and the subject calls for further examination. This task will be undertaken in detail in the next chapter, which deals with entrepreneurship. At this point we may anticipate to the extent of making two observations: first, the typical uninsurable (because unmeasurable and this because unclassifiable) business risk relates to the exercise of judgment in the making of decisions by the business man; second, although such estimates do tend to fall into groups within which fluctuations cancel out and hence to approach constancy and measurability, this happens only after the fact and, especially in view of the brevity of a man's active life, can only to a limited extent be made the basis of prediction. Furthermore, the classification or grouping can only to a limited extent be carried out by any agency outside the person himself who makes the decisions, because of the peculiarly obstinate connection of a moral hazard with this sort of risks. The decisive factors in the case are so largely on the inside of the person making the decisions that the "instances" are not amenable to objective description and external control.

III.VIII.28

Manifestly these difficulties, insuperable when the "consolidation" is to be carried out by an external agency such as an insurance company or association, fall away in so far as consolidation can be effected within the scale of operations of a single individual; and the same will be true of an organization if responsibility can be adequately centralized and unity of interest secured. The possibility of thus reducing uncertainty by transforming it into a measurable risk through grouping constitutes a strong incentive to extend the scale of operations of a business establishment. This fact must constitute one of the important causes of the phenomenal growth in the average size of industrial establishments which is a familiar characteristic of modern economic life. In so far as a single business man, by borrowing capital or otherwise, can extend the scope of his exercise of judgment over a greater number of decisions or estimates, there is a greater probability that bad guesses will be offset by good ones and that a degree of constancy and dependability in the total results will be achieved. In so far uncertainty is eliminated and the desideratum of rational activity realized.

III.VIII.29

Not less important is the incentive to substitute more effective and intimate forms of association for insurance, so as to eliminate or reduce the moral hazard and make possible the application of the insurance principle of consolidation to groups of ventures too broad in scope to be "swung" by a single enterpriser. Since it is capital which is especially at risk in operations based on opinions and estimates, the form of organization centers around the provisions relating to capital. It is undoubtedly true that the reduction of risk to borrowed capital is the principal desideratum leading to the displacement of individual enterprise by the partnership and the same fact with reference to both owned and borrowed capital explains the substitution of corporate organization for the partnership. The superiority of the higher form of organization over the lower from this point of view consists both in the extension of the scope of operations to include a larger number of individual decisions, ventures, or "instances," and in the more effective unification of interest which reduces the moral hazard connected with the assumption by one person of the consequences of another person's decisions.

III.VIII.37

The same reasoning holds good for any method of specializing uncertainty-bearing. Specialization implies concentration, and concentration involves consolidation; and no matter how heterogeneous the "cases" the gains and losses neutralize each other in the aggregate to an extent increasing as the number of cases thrown together is larger. Specialization itself is primarily an application of the insurance principle; but, like large-scale enterprise, it grows up to meet uncertainty situations where, on account of the impossibility of objective definition and external control of the individual ventures or uncertainties, a "moral hazard" prevents insurance by an external agency or a loose association of venturers for this single purpose.

III.VIII.38

Besides organized speculation as carried on in connection with produce and security exchanges, the principle of specialization is exemplified in the tendency for the highly uncertain or speculative aspects of industry to become separated from the stable and predictable aspects and be taken over by different establishments. This is, of course, what has really taken place in the ordinary form of speculation already noticed, namely, the separation of the marketing function from the technological side of production, the former being much more speculative than the latter. A separation perhaps equally significant in modern economic life is that which so commonly takes place between the establishment or founding of new enterprises and their operation after they are set going. To be sure, by no means all the business of promotion comes under this head, but still the tendency is manifest. A part of the investors in promoted concerns look to the future earnings from regular operations for their return, but a large part expect to sell out at a profit after the business is established, and to devote their capital to some new venture of the same sort. A considerable and increasing number of individual promoters and corporations give their exclusive attention to the launching of new enterprises, withdrawing entirely as soon as the prospects of the business become fairly determinate. The gain from arrangements of this sort arises largely from the consolidation of uncertainties, their conversion by grouping into measured risks which are for the group of cases not uncertainties at all. Such a promoter takes it as a matter of course that a certain proportion of his ventures will be failures and involve heavy losses, while a larger proportion will be relatively unprofitable, and counts on making his gains from the occasional conspicuous successes. That is—to face frankly that paradoxical element which is really involved in such calculations—he does not "expect" to have his "expectations" verified by the results in every case; the expectations on which he really counts are based on an average, on an "estimate" of the long-run value of his "estimates." The specialization in the speculative phase of the business enables a single man or firm to deal with a larger number of ventures, and is clearly a mode of applying the same principle which underlies ordinary insurance.

Note:
It would be out of place here to go into the social aspects of life insurance, but one observation may be worth making. From the social point of view it is arguable that all classification of risks is a bad thing, except in so far as the special hazard is purely occupational and the cost of carrying it can be transferred to the consumer of the product. It is hard to discover any good reason why the unfortunate should be especially burdened because of their handicaps. It would, therefore, be better if all were insured at a uniform rate. Indeed, we may go farther and contend that the rate should be graduated inversely with the risk (occupational risks excepted, as noted). It goes without saying that only a state compulsory insurance scheme could operate on any such principles; under private profit incentives, competition will compel any insurance agency to classify its risks as accurately and minutely as practicable.
Note:
Cf. Huebner, Property Insurance, chaps. XVI, XVII.
Note:
Cf. Willett, Economic Theory of Risk and Insurance, chap. III.
Pt.III,Ch.IX
Note:
The situation which we here endeavor to delineate is what Dr. A. H. Willett appears to have in mind under the designation of the "approximate static state." See The Economic Theory of Risk and Insurance, pp. 15, 16.

In this connection, again, we cannot be rigorously logical and definite without getting off into mere subtleties. We do not know whether there is ultimately real uncertainty and caprice in either physical nature or human nature. It may be that all changes are self-compensating some time, and that if progress were eliminated we should finally achieve prophetic powers in regard to phenomena in the aggregate (through application of the principle of consolidation) if not in individual instances. But in view of the tragically limited success of science in predicting the weather, for example, it is clear that there is no strain on credulity in assuming a large amount of real uncertainty. We must not forget that the periodicity of change or the interval required for canceling out of fluctuations is in practice relative to the length of human life. If such a cancellation would occur ultimately (as some writers, notably Nietzsche, have ventured to suppose) the period is so long in relation to human life that no advantage of it could be taken.

Note:
In actual society freedom of choice between employer and employee status depends normally on the possession of a minimum amount of capital. The degree of abstraction involved in assuming such freedom is not serious, however, since demonstrated ability can always get funds for business operations. A propertyless employer can make the contractual payments secure by insurance even when they may involve loss, and complete separation of the risk-taking and control function from that of furnishing productive services is possible if there is a high development of organization and a high code of business honor. But the conditions generally necessary in real life for the giving of effective guarantees must also be taken into account as we proceed.
Note:
It does not follow that he would have to own property, though in the real world this is the practical consequence. It is easily conceivable, however, that one might secure the payment of his obligations by pledging his own earning power. Such an arrangement need not call for more difficult feats of organization or involve greater strain on human nature than is true of indemnity insurance at present.

Part III, Chapter X.

Pt.III,Ch.XI
III.XI.41

The point which calls for emphasis is that where the possibility of securing wealth by the discovery of natural resources is known, along with something of the operations and outlays required, resources will be attracted into the field of searching for them in accordance with men's estimates of the chances of success in relation to the outlays to be incurred. The quest of wealth by this process thus becomes to those engaged in it an ordinary business operation, differing from the routine production of goods for immediate consumption in no matter of principle, though perhaps affected by a larger degree of uncertainty. And the same organization devices will be called into existence to deal with the uncertainty present—large-scale operations, the use of insurance where possible still further to broaden the base of the calculations, scientific research into the conditions of prediction and control of results, etc. Entrepreneurs engaged in exploration and development work bid in the same market against entrepreneurs in the fields of static industry for the same fundamental productive resources, and competition must fix a uniform price for both uses and bring about the same tendency to equality of cost incurred with output secured over the whole field of investment.

Pt.III,Ch.XII
III.XII.28

The conventional view is, of course, to regard risk-taking as repugnant and irksome and to treat profit as the "reward" of assuming the "burden." This is, of course, the business man's own idea of the matter, *62 and students of the problem have often held the same opinion. Thus Willett *63 argues that society pays for the sacrifice of assuming risk through higher prices for commodities in whose production it is a factor, for the reason that men are deterred from entering these occupations by their unwillingness to assume risk and that the supply of such commodities is consequently reduced. Ross also assumes *64 that risk is repugnant and draws the same conclusion, and Haynes *65 lays still greater emphasis on the influence of risk as a deterrent to production, quoting Andrews *66 to the same effect. Other writers have been more hesitant in generalizing or have made distinctions, or positively disagreed with this view. Thus v. Mangoldt *67 remarks that it is notorious that more money is lost than made in most forms of speculative activity and asserts the belief that this is true of business enterprise in communities which are in comfortable circumstances and have a reasonable surplus for embarking in venturesome undertakings. Professor F. M. Taylor also analyzes the problem with some care, *68 insisting that the profits of entrepreneurs may be either larger or smaller than the amount necessary to make up an insurance fund to cover actual losses. He holds it probable that they are for small risks larger and for large risks much smaller than the necessary insurance fund, but concludes that society has to pay a higher price for a particular commodity or service than it would have to pay if risk were eliminated.

III.XII.35

With most kinds of labor the chance element amounts to relatively little in all probability, and in any case it is perhaps best regarded as a return on the investment in special knowledge and skill rather than on effort directly. In any case, if Smith's reasoning is sound it appears that risk-taking is the opposite of irksome, that men work (or labor to acquire the capacity for work) more cheaply on the average for an uncertain than for a fixed compensation. To the landowner there is virtually no risk of actual loss involved in leasing it, and usually little or none of failure to receive the contract rental. In lending capital we find risk of loss of principal as well as interest and a great deal of attention is paid to the risk element in fixing the rate of return. A rate of pure interest is a concept to which it is so difficult to attach any definite meaning that it seems futile to speculate as to the adequacy of the excess of contract interest above this level to constitute an insurance fund to cover losses. The question, as before, is whether the actual receipts from contract interest and repayments of principal form on the average an amount equal to or less or more than the pure interest and the original principal. The writer sees no way of forming an opinion on this subject.

Note:
Economic Theory of Risk and Insurance, pp. 55-56.