HKB
$5000 or nothing, since the utility to us of $5000 is not twice as great as that of $2500.
The majority of business risks are not of a kind against which it is possible to insure. Insurance companies confine themselves to risks which are mainly a matter of what we call objective rather than subjective chance, i.e. risks in respect of which knowledge of detailed facts peculiar to the individual case is of minor importance. But such knowledge is of paramount importance in the case of ordinary business risks. If, for example, a new enterprise is to be undertaken, the special knowledge and experience which its promoters possess is a vital factor in determining their estimate of the risk involved. An outsider with no special knowledge would necessarily require to estimate the risk far more highly if we were to form a rational opinion on the basis of his knowledge. So great, indeed, would be the risk to him, that we can lay it down as a sound maxim that people are extremely rash who invest their money in risky undertakings about which they know very little. This subjective aspect of business risk has a significance to which it will be necessary to revert.
But, though most business risks are not and cannot be a matter for premiums and policies, the principle, which the practice of insurance illustrates, applies none the less. In the light of their knowledge and experience, the promoters of a new undertaking must weigh up the chances of failure and success, though they will not do so by the precise methods of an actuary. They will require that any chances of serious loss should be balanced by such chances of exceptional gain, as would raise the expectation of profit well above the normal return on secure investments. The more risky the project seems the greater, generally speaking, must be the expectation of profit required to induce people to undertake it.
If we suppose business men to calculate reasonably, it follows that the average profits in any industry over a long period of years, reckoning in the losses of the concerns which disappear altogether, are likely to be higher, the more risky is the industry. Such a result will not, of course, occur in every case. Even when the calculations are reasonable, they may be entirely falsified by the event. Moreover, business men may not calculate reasonably on the information which they have. But, unless we suppose their judgment to be subject to a prevailing bias in one direction, i.e. to be unduly optimistic as a general rule, we should expect, and in any case they must expect, profits above the ordinary in a risky industry.
This conclusion is sufficiently important. Far too many people, though they admit it when it is expressly stated and dismiss it even as a tiresome commonplace, are apt to neglect it when the occasion for applying it arises. For example, the great importance to any industry of good management is generally recognized, and the consequent desirability of paying adequate salaries to the managerial staff. The importance of securing a supply of capital is very widely recognized, and the practical necessity of paying a fair rate of interest is thus, however grudgingly, conceded. But the "residuary profits," as they are called, which accrue at present to the owners of a business, are denounced in some quarters in a sweeping fashion, which seems to ignore altogether the all-pervading element of risk. People speak as though you might appropriately limit profits in every industry to some uniform percentage on the capital employed, without making it clear whether you would even be allowed to make up in good years for the losses incurred in bad. The effect of introducing any such crude device into our present industrial system could only be to paralyze enterprises of an unusually risky kind, which, so far from being pushed to an excess at present, are more probably curtailed unduly from the standpoint of what is socially desirable. Like the fixing of a low maximum price for a commodity it would cause the supply to wither up and disappear.