How can we decide whether a risk is acceptable to society? Using the language of cost-benefit analysis, we can say that the risk is acceptable if its benefits to society exceed its costs. But to say this is merely to re-state the problem, for by assumption the benefits and costs are uncertain. Where these benefits and costs have known probabilities, and where individuals can diversify away their own risk through insurance and other markets, such a risk will be acceptable if its expected net present value is positive. This criterion is a standard rule used by managers for their investment decisions. But its prerequisites are most often not fulfilled. Three particular issues are important. The first is irreversibility. Some present choices reduce our freedom of action in the future. This loss of flexibility has a cost, or put another way, keeping options open has a value. There is also an insurability issue. Risk-sharing markets have been essential during the last two centuries to spread entrepreneurship risks in the economy. The third issue concerns the problem of the ambiguity surrounding the intensity of risk. It has long been noticed by economists and psychologists that people do not react in the same way when confronted with an objective probability distribution as when their assessment of probabilities is fuzzy. The absence of enough data to measure the risk seems to increase the social cost of risk.
Author: Christian Gollier
Source: European Business Forum (EBF)
Subject: Risk Management
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