Risk and risk-bearing

Front matter

HiioiS . W3

•

MATERIALS FOR THE STUDY OF BUSINESS

Table Of Contents

PAGE

CHAPTER

I. Forms and Extent of Business Risk . i

Chapter I

Risk may be defined as uncertainty in regard to cost, loss, or damage. In this definition, emphasis is on the word uncertainty. Where destruction or loss of capital is certain in connection with a business process, it can be charged up in advance as a cost. It is not a risk. When the destruction or loss is uncertain, it may be dealt with in accordance with judgments of probability, and presents a problem in risk. In this chapter our task is to make a preliminary survey of the forms and extent of risk involved in present-day economic life.

It is a common statement that risk is universal. As one author puts it:

The owner of wealth must, if he is rational, invest it in some productive enterprise, unless, under the circumstances, he decides to consume it; and, wherever it is invested, there will be some risk that part of it will be lost by the dishonesty of others, the deterioration in value of the property in which it is embodied, or in change of value of the standard of deferred payment. If he thinks to escape by hoarding it in the shape of specie, robbery is to be feared, to say nothing of the opportunities of gain' which are given up. If he decides to consume the wealth at once, he runs the risk of coming to poverty.1

Or, in Professor Fisher’s words:

If we take the history of the prices of stocks and bonds, we shall find it chiefly to consist of a record of changing estimates of futurity, due to what is called chance, rather than of a record of the foreknown approach and detachment of income. Few, if any, future events are entirely free from uncertainty. In fact, property, by its very definition, is simply the right to the chance of future services. A mine owner takes his chances as to what the mine will yield; the owner of an orange plantation in Florida takes risks of winter frosts; the owner of a farm takes risks as to the effect of sun and rain and other meteorological conditions, as well as risks of ravages of fire, insects, and other pests. In buying an overcoat a man takes some risk as to its effectiveness in excluding cold, and as to the length of time it will continue to be serviceable.2

1 John Haynes, “Risk as an Economic Factor,” Quarterly Journal of Economics , IX, 410.

2 Irving Fisher, Nature of Capital and Income , pp. 265-66.

Statements such as these, though strictly accurate, are, neverthe¬ less, apt to give a false impression of the extent, or rather of the importance, of the unknown element in human calculations. All these manifold risks do exist, but most of them are of no practical conse¬ quence. The only risks which need be given consideration in a business decision, or for that matter in any other decision, are the cases where the property interest, or other interest, at stake on the outcome of a single uncertainty is large relative to the total of which it is a part. For example, the risk of windows being broken by small boys is a real risk for owners of expensive plate glass windows but is of no practical significance to owners of an equally large amount of capital in the form of many small windows.1 Risk in any practical sense is not present in all our calculations.

Uncertainties of practical importance to the business manager may conveniently be classified in accordance with their origin, as follows:

1. Risks of destruction of property through the physical hazards of nature: storm, flood, fire, etc. These are among the most serious hazards in many lines of business, notably in live stock raising and in transportation. Most of the losses caused by hail, flood, and storm would be avoided if we knew in advance what conditions to expect. They are part of the cost of our ignorance. To measure the total cost, however, we must add to the actual losses the cost of precautions taken against disasters which never occurred, and the loss of produc¬ tion on account of the existence of these risks.

The magnitude of these losses reflects primarily the extremely rudimentary development of our science of weather forecasting. The extreme range of our ability to forecast deviations of weather from its past average is less than a week, and tolerably accurate forecasts can be made only twenty-four to forty-eight hours in advance. Even this limited range of forecasting, however, has tremendously reduced the volume of losses from weather conditions.

2. Closely related to the preceding are uncertainties in the productive process. — In spite of the immense advance in applied science in the past 150 years, there still remain numerous points where commitment of capital is based on uncertainties. Strength of materials is one such

1 Of course in the illustration given the coincidental breaking of all the small windows is a theoretical possibility, and, if it occurred, would be quite as serious as the breaking of the one large one. The point is that such coincidences are so extremely rare that their possibility may be disregarded entirely. The justifica¬ tion for this treatment of infinitesimal risks is developed more fully in chap, ii, note 1.

weak point in our applied science, particularly in the case of materials which have suffered depreciation in use. The effectiveness of labor is another point at which advance estimate and final result are apt to vary, and variations of weather make agricultural production notori¬ ously speculative.

3. Social hazards include the risks due to deviations of individual conduct from what is expected , such as robbery, defalcation, and forgery, and also risks due to the impossibility of predicting the behavior of social groups. Strikes, riots, wars, tariff changes, tax reforms, pro¬ hibitory laws illustrate the range of these risks.

4. Risks due to individual ignorance cause many losses and make possible many profits. — In a sense all risks are due to ignorance, for if all the conditions of any situation were known there would be no risk involved in it for anyone. There is, however, a distinction worth maintaining between risks due to the limitations of human knowledge and risks which are due to the failure or inability of individuals to take advantage of the knowledge which is accessible to themselves or to those with whom they come into competition. It is risk of this character which keeps down the competition to seize favorable busi¬ ness openings and makes it possible for persons of superior knowledge and skill to profit by their superiority. Potential competitors are kept out of the field by their ignorance of its existence or its extent, and many who do enter are unable to compete effectively.

5. Market risks form the most important group of all. — By market risks we mean the unavoidable uncertainties due to the fact that time elapses between the purchase and the sale of commodities, during which time unpredictable changes often occur in the prices and other market conditions surrounding the commodities dealt in. Rarely is it possible to conclude both the buying and the selling part of a given transaction simultaneously, so as to relieve the business man of risk, and even when it can be done there is risk that he will be held to one contract and be unable to enforce the other.

The extent to which the time element makes business risky has been indicated by President Hadley:

Down to the present century, a large part of the speculative profits were made by taking advantage of differences of price in different places — chiefly in connection with foreign trade. The means of communication and trans¬ port were so defective that there was often a great scarcity of an article in one region and an abundance of the same article in another. The shipowners who moved the article from the latter place to the former had a chance of enormous profits. But the business was also attended by great risk. Transportation was far less safe, either from the elements or from human violence, than it is today. There was no telegraph, no good postal service, no efficient protection from pirates by sea or highway robbers by land. All these causes combined to render the arrival of goods so uncertain that the very wages of the seamen were made contingent upon the safe delivery of the cargo, and the whole body of sailors thus became participants in the speculation.

The nineteenth century has witnessed a change in these respects. Improved means of communication have greatly lessened the differences in price in different markets. It is no longer possible to have a glut of wheat in Chicago and a scarcity in Liverpool. The modem post-office and the telegraph furnish prompt information of what is going on all over the world and enable merchants to know where goods are most needed. The steamship and the railroad furnish a quick and safe means of placing the goods where they will meet such needs as may arise. The difference of price of any staple article in two large wholesale markets will not generally be much greater than the cost of transportation from one to the other. So moderate have the profits from this source become that the business of those who try to secure them is now known as arbitrage rather than specula¬ tion. Only in the trade with barbarous or half-civilized races does foreign commerce retain its character as an extra-hazardous business.

The speculator of today makes his money chiefly by taking advantage of differences of price between different limes rather than between different markets. It is not so much the difference in the price of wheat in Chicago and in Liverpool which furnishes the source of his profits, as the difference between its price in Chicago this month and next month. When such speculation anticipates an actual demand, it is of great service to the com¬ munity. The long time which elapses between production and consump¬ tion, between contracts and their fulfilment, makes it extremely important to have responsible men to anticipate the wants of the market and take the risks on their own shoulders.1

It will be noted that from the standpoint of risk it makes no difference whether the buying or the selling occurs first. In many cases the business man contracts to deliver a certain commodity at a given price, then purchases the things he needs to fulfil his contract. The sale of a newspaper subscription, a building contract, the collec¬ tion of university tuition, are all transactions of this character. More frequent are the transactions where something is bought first with the idea of selling it, or some product into which it enters, at a profit.

‘Adapted by permission from A. T. Hadley, Economics, pp. 104-5. (G. P.

Putnam’s Sons, 1899.)

Sometimes both elements are present in the same transaction, as when a tailor first buys cloth, then after taking an order for a suit, buys the labor to make it up. In all transactions of either of these types, and it must be repeated that practically all business is of one type or the other, the longer the time involved in the fulfilment of obligations entered into, or in the disposal of commodities bought, the greater the risk of adverse changes, either in price or in other market condi¬ tions. Declines in price of one’s product occurring after capital has been sunk in plant and inventory have probably ruined more businesses than any other single group of causes. Increases in cost of materials and labor after contracting to sell one’s product are sometimes equally disruptive. Such changes in prices may be due to decline of demand arising from a change of consumers’ tastes — the collapse of the Ameri¬ can Bicycle Company is a good illustration; or to appearance of a more efficient method of production, as in the supplanting of hand weaving by factory processes; or to the appearance of a rival com¬ modity which renders a superior service, as when the tungsten filament supplanted the carbon for electric lighting purposes; or to changes in the general level of prices, as is illustrated by the decline of gold¬ mining during recent years of advancing prices.

Of course the conditions which give rise to the chance of adverse changes also bring the chance of favorable changes. When the probability of such unpredictable changes, one way or the other, is considerable, and business is entered into with a view to profiting by a preponderance of favorable changes, the business is said to be of a speculative character. If the capital invested is highly specialized, the speculative element is increased because of the impossibility of recovering the investment if things go wrong with it. Real estate, grain, cotton, fresh fruit and vegetables, sugar, live cattle and hogs, horses are dealt in largely as speculative commodities, though in marketing many of these commodities it is feasible to reduce the speculative element in business by “hedging.” (See chap, xii.)

In most lines of business profit does not depend upon favorable changes in the market, and the owner-manager would gladly give up his chance of profit from fluctuations of the market for the sake of freedom from its risks. The fluctuations, like the physical hazards referred to above, are a disturbing element, and though they may give rise to as many gains as losses, the necessity of taking precautions against them involves a cost which is a dead loss to the group as a whole. In strictly speculative lines, on the other hand, the fluctualions are the chifef source of profit, though here also they may give rise to as many losses as gains.

In relatively few cases does a highly speculative business derive its character from uncertainties in the productive process. Mining and oil-drilling furnish the best examples of this sort of risk. The development of inventions is highly speculative, partly because of market considerations and partly from uncertainties connected with production.

The following comparison of the uncertainties involved in produc¬ tion and in marketing brings out other reasons for the emphasis which has been laid on the market as a source of risk:

In the field of production, of course, the body of knowledge is on the whole better organized and more precise. The various systems of manage¬ ment relate more to production than to marketing.

Though a vast field for research, marketing has had comparatively little scientific study. It has not seemed particularly susceptible to scientific study. It abounds in the human equation. This does not mean that much ability has not been expended on this field not only in studying and inciting demand but also in recording performance. Map and tack systems, quotas and bonuses, selling costs and carefully prepared statistics of various kinds have for a considerable period been employed by the most progressive selling organizations. These internal statistics have also been accompanied by external statistics affecting and reflecting market conditions. But in the last analysis, the figures finally used in marketing, however obtained, are based on the law of averages, frequency, or proportion; the standards set, no matter how carefully and specifically adjusted, are in the last analysis averages, modes, or proportions and apply en masse rather than in detail. This does not mean that these data are not regarded as exceedingly valuable. Nevertheless a great problem in marketing is to get down beneath the law of averages and types.

Production is so much more specialized and standardized, so much more precise than marketing, that it is possible, given certain facts of material, dimension, and design, to set a maximum time for the performance of a certain specific operation. The appliers of scientific management have, furthermore, shown the possibility of determining a minimum time for this operation with conditions continuing the same and of prescribing the means whereby this minimum time need not be exceeded. In other words, the scientific manager in production cannot only tell William Jones how long he should be in machining a certain part, but can furnish him with the best feeds and speeds to employ in doing the work in the time specified, and if the methods and time apply in Philadelphia it is presumed that they will also apply in Boston. But in marketing, no manager, no matter how able and experienced, would attempt to tell Thomas Smith how long he should be in selling a pair of shoes to William Jones, nor to give more than general instructions as to the best way in which to do the selling. About the best this manager has been able to do is to say that in a week, on the average and according to the season, Thomas Smith should sell so many dollars’ worth of shoes. In machining the part, the conditions are more stand¬ ardized, the operation more specialized, the human factor is smaller and is more under control. In selling the shoes, the opposite is true. In produc¬ tion, the time for an operation can be measured by minutes and less; in marketing, I have encountered no practical use being made of units of less than one week.

This warrants the consideration for a moment of certain fundamental differences between production and marketing. These differences may be balanced against each other as follows. In production, men meet only as members of the business — as subordinates, peers, or superiors. Neither the customer nor the competitor is encountered directly. In marketing, on the other hand, men are in contact not only with the other members of the business, but also with the customer to serve and the comnetitor to meet. In production, the problems are likely to be more those of cost — material, labor, and overhead. In marketing, the attention is more focused on price. Knowledge of cost is not particularly essential. The market is fixing values outside of the business’ control. Emphasis is also likely to be laid on quality and service. In production, the problems on the whole are internal. In marketing, the problems on the whole are external. Com¬ petition is on every hand. The market is to be analyzed. In production, there is probably for the individual business a possibility of greater inde¬ pendence of action. Marketing is probably more hedged about by the customs of the trade. In other words, as said before, marketing abounds in the human equation.1

The last sentence in the preceding selection touches one of the fundamental and irremovable elements of uncertainty in the business man’s problem. “Business touches the human equation.” That is, the decision of a business problem depends on a judgment as to what certain individuals will do under given, or partially given, circum¬ stances. This is always fraught with uncertainty, if for no other reason because if A’s decision depends on what B will do, and B’s decision on what A will do, ;t is obviously impossible for both to get all the data they need. The only way in which one can arrive, even in theory, at a scientific solution is through a rigid exclusion of free

1 Adapted by permission from S. O. Martin, “Scientific Study of Marketing,” in Annals of the American Academy of Political and Social Science , LIX (1915), 78-80.

choice from his interpretation of human conduct; but on such an interpretation the business manager himself would have no interest in the result of his analysis anyway, as his own action would be determined outside his own choice.

Moreover, quite apart from the theoretical impossibility of arriv¬ ing at a scientific judgment in matters of human conduct, the business manager runs quickly into serious practical difficulties. Time and cost set limits to the extent of his researches. No more than a general in the field can he wait till all the relevant facts have been gathered, nor can he afford to spend in their collection an amount greater than they will add to his profits. Even these limits he cannot definitely know. How much time, how much money it is worth while to spend in trying to complete the data on which to base a given decision, depends on facts which frequently cannot be known till the investiga¬ tion is complete and the decision has been made.

In other words, the choice between two business policies or lines of action is in most cases not comparable to the solution of an algebraic equation, a type of problem where two trained minds may be expected to arrive invariably at the same conclusion. Sometimes it is rather like the translation of an inscription on a defaced monument where some of the words can be deciphered with ease, some can be made out with the aid of photography, and some can only be conjectured. Sometimes it is like a question of ethnography, where the expense of collecting data concerning an uncivilized race may make it necessary to depend on the unconfirmed accounts of a few travelers. Sometimes it is like the decision of a general in the field, where action must be taken at once, without waiting for the much desired information to arrive.

The conclusion is not, however, that since we cannot know all we would like to know we cannot conduct ourselves rationally. If time or cost prevents our reaching a valid final judgment, there still remain several ways of meeting the situation. To these we will give atten¬ tion in chapter ii.

1. “The grower, the manufacturer, and the merchant must speculate.” Why?

2. Are risks greater in a changing condition of industry? in a market of greater time area ?

3. Commercial speculation may concern itself either with the time area or the space area of the market. Explain.

4. How does the “ roundaboutness ” of modern industry affect risks?

5. Explain how the presence of highly specialized capital goods in modern industry accentuates risk.

6. Does expanding education have any tendency to increase risk ?

7. How has the development of improved transportation and commu¬ nication affected risk ?

8. Do you gather that risks are increasing? Is there any answer to this question? Suppose they are increasing; is society worse off?

9. “Business touches the human equation.” Explain.

10. Try to outline what would be involved in a complete elimination of significant risk in our business life.

Chapter II Of The Risk

It is clear enough that there is no escape, present or future, from the presence of uncertainty in the administration of business, and that we must accordingly deal with risk. The elimination of the risk requires the elimination, not of the loss or damage itself, but of the uncertainty concerning its time or place or extent. Usually this involves the substitution for the uncertain loss of a smaller but certain loss in one form or another. This cost, for instance, may consist of the price of a safety device, which may never be used or needed but if it is needed, may save many times its cost — it may be an insurance premium, or it may be the cost of an investigation to remove the uncertainty.

Methods of dealing with risk may be analyzed into the following types:

A. Elimination of risk by:

1. Prevention of the harmful events

2. Forecasting, or research to remove the uncertainty

3. Combination of risks

4. Accumulation of reserves to provide for meeting the risks

5. “Compensation,” or offsetting of risks

B. Assumption of Risk

1. By owner-managers

2. By investors and speculators

3. By laborers

C. Transfer of risks to others

1. Transfer to entrepreneurs, from

(a) Laborers, through the wage system

( b ) Capitalists, through the interest system

2. Contracting out

4. Insurance

5. Guaranty, suretyship, underwriting, etc.

II

The present chapter deals with the various methods of eliminating risk.

1. The prevention of harmful events is an ancient and universal method of reducing risk. — No very detailed discussion of this method of dealing with risk is necessary. Umbrellas, lightning rods, fireproof walls, and burglar alarms furnish everyday illustrations. Science and invention are constantly improving our technique for the removal of risk by prevention of harmful events, sometimes by the development of new methods, oftener by what is quite as important, the reduction of the cost of old methods.

2. Reduction of risk by research has greatly increased in impor¬ tance. — As civilization advances the relative importance of science grows. On the one hand, the mass of accumulated information and experience requires more study and more specialization for its mastery; on the other hand, the complexity of the problems to be handled, the magnitude of the enterprises to be controlled, make such mastery ever more necessary. Just as in the latter part of the Middle Ages the trained lawyer gained control of the administration of justice, and a little later the physician wrested physic from the barber, so in the nineteenth and twentieth centuries the construction engineer sup¬ plants or directs the rule-of-thumb contractor, the works engineer who grew up in the plant gives way to the engineer with technical training, the trained nurse ousts the “practical nurse.” The increas¬ ing importance of science in business is merely one illustration of its increasing importance in all human affairs.

The same factors which have brought about the development of scientific method in other fields have been operative in the field of business management, and here as in other fields the recognition of the value of exact knowledge and intelligent planning, though recent, has been very rapid. Whether the problem in hand is that of choos¬ ing a location, promoting an official, canceling a purchase order, refund¬ ing a bond, or writing an advertisement, the business manager has a choice of the two methods of procedure — snap judgment based on tradition, personal experience, haphazard information, and the cir¬ cumstances of the moment, or careful judgment based on investiga¬ tion of all the available data. So far as may be, he should rely upon the latter. One of the principal functions of formal education for business, indeed, is to indicate the value in business of modern methods of scientific analysis in such varied forms as the development of com¬ mercial research for the management of the market; of psychological and social investigation as a guide in the administration of personnel problems; of time study, laboratory analysis, and other technical methods of attack on the technical problems of production; of cost accounting as a guide in directing business policies.

The following selections describe certain aspects of the trend of business in recent years toward more exact scientific methods:

MARKET ANALYSIS1

In order to determine to what particular class of customers his sales campaign should be directed, a manufacturer finds it necessary to study his market carefully under present conditions of keen competition. Blun¬ derbuss methods are wasteful; hence they are becoming antiquated. The demand for any article varies according to purchasing-power, living condi¬ tions, occupations, racial characteristics, climatic conditions, and numerous other influences affecting the different classes of consumers. The object of market analysis is to determine which class or classes of consumers con¬ stitute the potential market for the product, to ascertain where that class is located, and to find out what channels of distribution are most readily available for reaching them.

There are few, if any, commodities for which equal per capita sales may be expected in all sections of the market, provided the market is more than local in its scope. In each district there are numerous classes of consumers with widely different tastes and desires, and the relative pro¬ portions of these classes in different districts always vary. In New York City, for example, the population of the metropolitan district in 1910 was 6,475,000. In the same year the population of the Cleveland metropolitan district was 613,000. From these figures it cannot be assumed that the New York market for any particular article is potentially ten times as great as that of Cleveland. New York represents the extremes of wealth and poverty. Fifth Avenue and the Lower East Side are at opposite ends of the economic scale. Their wants and their purchasing power are wholly unlike and each differs from the large middle-class strata. In Cleveland the relative proportions of these several classes, with their numerous grada¬ tions of purchasing power and of wants, are not the same as in New York. The population of Cleveland, furthermore, differs in its composite parts from that of Cincinnati or other cities, and these differences in the make-up of the population affect potential demand. Another line of demarcation is between urban and rural districts. Because of these diversities a reliable estimate of potential demand can seldom be made upon a gross per capita basis.

In analyzing the market for some products, conditions other than those of a strictly personal nature must be taken into account. A manufacturer

1 Adapted by permission from M. T. Copeland, Business Statistics , pp. 178-83. (Harvard University Press.)

of electric flat-irons, for example, in analyzing his market found that in one city of 300,000 population 25,000 families were supplied with central station electric current. Thus there were 25,000 possible customers in that city. In another city of approximately the same size only 3,000 families were supplied with electric current; hence the potential market in this second city was much smaller.

For some products the market is clearly denned; in such cases the market is easily analyzed by the manufacturer. The manufacturer of machine tools, for example, knows that his product can be sold only to machine shops and engineering works and his task is to learn all the establish¬ ments existing and planned for in the territory that he wishes to cover with his sales organization. A similar situation confronts other producers of equipment and materials that are sold to manufacturers. Certain manu¬ facturers of specialties sold to other classes of customers can encompass their market in a list that does not assume excessive proportions; a manu¬ facturer of surgical appliances, for example, can readily obtain and utilize a practically complete list of possible customers. For the great mass of goods sold at retail, however, and for general supplies sold to manufacturers, the market is of a different type and potential demand is much less easily estimated.