Production and Risk

Great Debates
41

The prior agreement vs measure of risk is not a mutually exclusive point.

What you’re glossing over is the nature of that agreement, and what you’ll find is the it spells out,

wait for it

wait for it

how risk is shared!

From your OP Allison and Sarah could have had a prior agreement, that would have spelled out how risk is shared. Allison putting up cash, Sarah investing talent. Both get a portion of the proceeds.

From my OP: the dishwasher and the owner have a prior agreement, show up and wash dishes, earn $10 an hour. The dishwasher chooses to avoid risk in exchange for security. No not job security that’s absurd, but guaranteed return on investment*. The dishwasher puts in an hour of investment, and gets $10 in return. The owner doesn’t get that guarantee. She might put in 80 hour weeks for a year, only to see her business fail. She also might put in 20 hours a week and hit the jackpot.

Go back to the casino example: If I put down $20, I stand to win or lose. If I pay someone $5 to make the bet for me, we have an agreement to share the risk in that he is guaranteed $5, but not a penny more. His level of risk is perfectly matched by his reward, which is completely independent on my level of risk.

There is no reason we couldn’t have a prior agreement to share the risk. It could be a shitty agreement like, “I’ll pay you $1 to make the bit, if it wins you get a $4 bonus.” Consider that for a money in the context of a casino. If you think I’m skilled and know where to place the chips, you might opt to share in the risk. Now your real risk is that you could choose to work with another gambler that could be more or less successful.

You’ll notice that my broker wants a $5 commission, regardless of whether or not my trade is successful. If my stock takes off tomorrow, there is no way in hell I’m giving him more than $5 when I sell. He gets the $5 off all my failed trades, and that’s his choice. He can’t have it both ways. Either he takes a loss with me (perhaps zero commissions on losing trades) or he forgoes my winnings (getting just $5 regardless of what I earn).

That’s how the prior agreements work, they spell out how each individual will be compensated for their level of risk. And what you’ll see is that it lines up pretty fairly such that those who are guaranteed something get less of the profits than those who are not guaranteed.

*assuming solvency

42

I think you’re overusing (and misusing) the term “risk” more than a little bit, emacknight. Individual participants in a business enterprise do definitely experience forms of risk, depending on a variety of factors including the nature of their investment, but the risks to the enterprise are shared (in general) according to each participant’s stake in that enterprise, rather than those stakes being determined by the share of risk.

Your dishwasher gets a wage rather than a share of profits not because he chooses the guaranteed rate of return on his labor, but because that’s the equity agreement available to him. The restaurant owners can structure a different form of contract for dishwashers if they choose to, but since they don’t have to offer anything but a wage, it would make no sense to offer shares. The inherent or incidental risks involved in the process of washing dishes are shared between the worker and the owners, but they have little to do with setting the hourly wage offered to the worker.

43

You could say the agreements are about how risk is shared, or that they’re about how profit is divvied up, or that they’re about how proper respect will be shown for each individual, or any number of other things besides. All agreements could be described in any of those (or any number of other) terms. That seems to me to be beside the point. But:

What I’ll see when I look where? What lines up?

I ask because I have been confused about whether you are making a descriptive or a prescriptive claim. I thought, usually, prescriptive–but its lines like this that make it seem you’re going descriptive.

Descriptions and prescriptions are to be argued about differently, so it’s important to know which one you’re engaging in.

44

I guess I wasn’t clear on which side of the argument you were trying to make.

This is where I think your definition or understanding of “risk” might not make sense or may be applied incorrectly. From a strictly financial definition, we think of “risk” in terms of the liklihood that you will not make a positive return on your investment. I have a thousand dollars. If I put it on a roulette table, I have a certain percent chance of losing all of it and a smaller percent chance of making money. Whether I choose to invest/gamble that money is determined by whether I think the rewards outweigh the risks.

So yes, we are in agreement that what you deserve is established by the agreement you enter into. But the riskiness of my investment is not an entitlement. Risk is used to judge the worthiness of entering into the agreement or making financial decisions.

As it pertains to real life. A business consists of freely entered into agreements between parties. Owners, managers and employees. Customers and vendors. So on and so forth. Businesses only exist, however, because people with capital choose to take risks with that capital in order to build something that will create wealth. Their risk doesn’t entitle them to the profits. Their ownership does.

Assuming you live in the USA, why do you say that?

45

I totally agree. But you’ll have to take this up with emacknight who (unless I’m horribly misunderstanding him) has been explicitly defending the view in this and other threads that risk does amount to entitlement.

That’d be a matter for another thread. :wink:

But as a tantalizing hint concerning what I mean, I’ll just note that “can choose” is an ambiguous and slippery phrase.

46

Yes, you and multiple others willfully misunderstood what I was saying. From the other thread:
The owner is the one risking capital, so the owner is the one entitled to the resulting profits. A phrase some found humorous.

What ever risks the dishwasher faces are rewarded in the form of salary. If after an hour the restaurant fails, the dishwasher earns $10 and the owner loses $10k. If after an hour the restaurant is a glowing success, the dishwasher makes $10 and the owner closes shop and walks away with his initial investment plus profit.

47

I think you have it backwards. The rewards are divided up based on each persons share of risk. One person might risk cash, another person might risk reputation.

Personally I think a lot of businesses would love to pay people in shares. But how many people are willing to forgo salary for the potential pay off? The dishwasher wants cash in hand at the end of his shift, not a slip of paper that may or may not have value in a year.

48

bolding mine.

Screw you, buddy.

Which appears to be a case of you saying that risk amounts to entitlement, correct?

Which again appears to be a case of you saying that risk amounts to entitlement, correct?

How have I misunderstood you, “willfully”* or otherwise?

*Again: A-screw. Ya-hou. Buddy.

49

Let’s see what I said:

"The owner is the one risking capital, so the owner is the one entitled to the resulting profits. "

You willfully ignore those words between risk and entitlement. As an example:

The chef is the one risking his reputation, so the chef is the one entitled to the resulting fame.

No one else in the enterprise gets to consider themselves skilled at the end of the year other than the ones that invests their skill and reputation–hence putting it at risk.

Why is this causing so much grief with so many people?

Is it because I said the dishwasher doesn’t take any risk? Is it because you want the dishwasher to earn more?

I’m sorry this touches such a sensitive nerve, but the person that risks capital is the one that is entitled to the gains.

50

Risk is shared among stakeholders, just as reward is shared. There are risk factors that fall more heavily on some depending on their role, tasks or other situational variable, but the very idea of a “stake” is to share risk and reward. There just isn’t an invariable natural relationship between individual risk and reward. And if we’re talking about the negotiated value of labor, other factors have far greater importance in setting that value than relative risk involvement of the laborers.

Regardless of whether those two options are mutually exclusive (they aren’t) or whether payment in shares would be desirable by owners to every participant regardless of their role (it would not), the fact remains that the wage set for hourly workers is not based on ‘desert’ proportional to risk.

51

What touches a sensitive nerve is being told I’m “willfully” misunderstanding you. That indicates you do not trust me to engage in this conversation honestly–despite the fact that I have engaged in it perfectly honestly, indeed gently and with some humor and conscientious humility (due to the fact that I know I don’t know much about the topic)–and can not imagine what sign I’ve given otherwise.

The person I was responding to said risk doesn’t amount to entitlement–and he and I were at that time speaking in terms of risk of capital. When I said you defend the view that risk does amount to entitlement, it was to be understood that what you were saying is that risk of capital amounts to entitlement. That is what the person I was talking to disagrees with (and I tend to disagree with you about that as well).

We all know: You’re talking about risk of capital. I was not intending anything else by what I said.

Back to the topic:

What is capital?

52

Or rather, you mean:

X’s risking Y entitles X to Y-like rewards.

I didn’t mean to say you meant anything other than that.

You are saying risk amounts to entitlement in that sense–and that’s the sense in which I and the other person I was talking to disagree with you. It’s not the risk that entitles, it’s the agreement.

You said earlier that if I look, I’ll see the agreements match up with your scheme. I asked you in response, if I look where? I’m not sure if you’re making a prescriptive or a descriptive argument and I need to know.

53

Generally speaking anything that can have value. Most frequently it refers to cash, land, real estate, equipment, or inventory.

It can also include the promise of future gains such as debts owed or tax with holdings owed.

But as I’ve shown skill, reputation, and time can also carry value and be put at risk.

54

What is the agreement you’re talking about?

If I bet $100 I have an agreement with the dealer?

If we each chip in $50 we agree to split it?

Obviously we two or more people are involved there needs to be some understanding of how the rewards and losses will be shared.

I guess when I said, “look at the agreement” I meant that 9 times out of 10 the agreement is pretty straight forward where risk matches reward. If I put in $10 and you put in $90 we’re not each getting 50% of the rewards, it’s more likely to be a 10:90 split.

The 1 time out of 10 is when an extenuating circumstance alters the nature of the relationship. If you need 90cents to buy a lottery ticket, and bare with me because this gets a little wiggy, if you need my investment, I can negotiate a disproportionate reward. I might size you up and realize this win means more to you than the loss does to me, so I’ll seek to push my advantage. It might also go the other way, if I have 90% of the down payment I need, you might offer up the 10% with strings to make the deal favourable to you.

It’s possible people are focusing on that relationship in spite of the other.

I’m really not sure how to answer that. What I meant was that you need to look at the agreement, that will spell out how risk/reward is divided.

55

Do you mean that roughly nine out of ten (or in other words, the great majority) of actual agreements people enter into (when they involve risk and reward) assign reward directly on the basis of risk?

If that’s what you mean, there are two things to say:

  1. That’s an empirical claim, which it might be interesting to investigate.

  2. As it is an empirical claim, it doesn’t tell us anything about what people deserve. Desert is a moral concept. It may well be that people almost always enter into the kind of agreement you describe–but they should be entering into some other kind of agreement instead. What’s the argument that people should be agreeing to make reward proportional to risk?

56

Why do you guys keep writing desert?

So you’re right, it might not be what people always deserve. But how the hell do propose we flesh that out?

We’re also going to run into the very real possibility that each person feels they deserve something different, most likely at odds with the other parties involved, and even more likely it involved getting more and losing less.

Lastly, if you remove desert from the dinner, some people might not decide to eat. In other words, if you own a casino and want to lure in whales, you probably shouldn’t tell them they don’t deserve to win.

It’s possible my bank doesn’t deserve the interest on my loan, frankly I think it deserve it much more than they do. But without interest my bank isn’t going to issue the loan. Dare I say, giving me a loan is risky, and they want compensation for that risk.

57

:confused:

Are you not talking about what people should recieve under various circumstances?

What they should recieve is what they deserve, by definition. Isn’t it?

Maybe you’re assuming I mean “deserve” in some moral sense. I don’t. I just mean “what people should receive.”

That’s why we make agreements–so that it is clear from the outset, formally, what each person is supposed to receive.

Suppose its true that nine out of ten agreements make reward reflect risk. What I’m saying is that doesn’t mean that agreements should be like that. It just shows that they in fact are like that. The question is, should they be? What’s the argument that the kinds of agreements we’re discussing should make reward directly and proportionally reflect risk in the way you’ve described? This isn’t something you can just assume. It doesn’t fall out of the term “risk” by definition or anything like that (unless maybe you think you can show that it does?).

58

I can’t tell if those people are being too smart or too stupid. Probably why half the SDMB makes $20k a year.

I understand what you mean, but perhaps I can lend some clarity. technically, it is not the risk that entitles the owner to the profits. It is that right of ownership that the capital provides. In fact, risk can be deferred elsewhere (through insurance or other hedge).

Yes. The terms of the wager is your agreement.

59

:smiley:

I don’t know if you guys are both whooshing each other or if there’s a true misunderstanding.

The word spelled desert is this thing: Desert - Wikipedia

The word spelled dessert is this thing: Dessert - Wikipedia

Typically, the words are not interchangeable and will affect the meaning of your argument profoundly.

And Frylock, as far as your thinking that our current framework of financial risks and its resultant rewards is purely artificial is completely wrong. It actually does have a basis in our natural psychology. It flows all the way back to how humans motivate themselves for major projects and what they expect to receive out of it. It’s been that way as far back as the dawn of civilization – whether it’s preparing wooden spears and waiting in a bush to hunt down woolly mammoths or investing $X amount of dollars in an unproven business. To ignore all this is to be naive about our natural biases for distributing rewards (desserts?).

60

Of course, to be clear, I was using the word “desert” in the sense of “desert[sup]2[/sup]” from this link.

I note that that definition includes a moral element. I thought you could use it without moral connotation, but perhaps not.

I thought a trend in Economics these days was to discuss the various ways humans are horrible at estimating risk and matching it in any sensible way to reward. Everyday experience would seem to bear this out.

But if humans are bad at this, doesn’t this suggest that we are not psychologically driven to match risk to reward? We throw a bunch of other stuff in there besides, making things such that if you read us as trying to match risk to reward, we look like we’re not very good at what we’re doing–when actually there’s something different that we’re trying to do. (Kind of like saying a kangaroo isn’t very good at flying because he only jumps so high but no higher…)

Moreover, suppose we are psychologically driven to match risk to reward. What should we take away from this fact? Why does it matter? Evolution doesn’t optimize–it only comes up with solutions that are good enough. Moreover, it’d take some doing to argue that evolution selected human psychology for its economic effectiveness. So even if we’re psychologically driven to match risk to reward, that doesn’t imply that matching risk to reward is what we should be doing. Following our instincts here might be the very thing holding us back just as following our food-consumption instincts tends to lead to obesity and heart troubles.