The Economics Book

162

SOME PEOPLE

LOVE RISK,

OTHERS AVOID IT

RISK AND UNCERTAINTY

T

here is an element of risk

in any business venture

or investment in a market

economy. Before deciding on a

course of action, an individual has

to consider the possible outcomes

and weigh their potential returns

against their probability, that is,

calculate the “expected utility.” If

there is a safe alternative, this one

is generally preferred to the riskier

option, unless the expected return

on the riskier option is considerably

more attractive. The greater the

risk, the higher the profit has to be

to attract investors.

The similarity to weighing

the odds in gambling is clear, and

early studies of risk were made by

18th-century mathematicians, who

Some people love risk,

others avoid it.

IN CONTEXT

FOCUS

Decision making

KEY THINKER

Frank Knight (1885 –1972)

BEFORE

1738 Dutch-Swiss

mathematician Daniel

Bernoulli formulates a theory

of risk aversion and utility.

AFTER

1953 French economist

Maurice Allais discovers a

paradox in decision making

that contradicts expected

utility theory.

1962 US economist Daniel

Ellsberg shows how people’s

decisions in conditions of

uncertainty are not based

purely on probability.

1979 Israeli psychologists

Daniel Kahneman and

Amos Tversky question

the rationality of economic

decisions in their prospect

theory, based on real-life

experiments.

Less risky investments

tend to have lower returns.

Risk-averse investors are

prepared to accept a lower

payoff in order to get a

guaranteed return.

Riskier investments tend to

have higher returns.

Risk-loving investors

are prepared to accept

more risk in order to get

a higher return.