I often tell my students that, no matter what they major in, they are a business major. That’s because they will eventually go out into the job market and earn money. And whether they work for government, industry or a nonprofit organization, ostensibly, they are conducting business. Then I ask them: and by the way, how do you make money in business?
After I get a few answers, such as getting in on the ground floor of an internet startup company or finding investors or hiring workers, I tell them the answer: You have to take risks in order to make money. Why? Well, if making money were easy and 100% guaranteed, then everyone would be starting companies.
Therefore, business involves a certain amount of risk, such as not getting customers in the door, unforeseen accidents or safety violations, or making an error in cost estimations that creates excessive cost overruns. We know mistakes can happen and we simply try as best as we can to account for those mistakes based on what we believe are the probabilities and costs involved. And it is that probability aspect that we most associate with business risk.
It reminds one of playing roulette in Las Vegas while an Elvis Presley impersonator sings “Jailhouse Rock” in the background. That is, when you are playing roulette and you place a bet, there is a 45% chance that the ball will land on a black slot and a 45% chance that it will land on a red slot. Worse, there is a 10% chance that it will land on the two green slots where the money goes to the house. So, a bet on black has a 45% chance of doubling your money and a 55% chance of you leaving Las Vegas with nothing.
Frank H. Knight explained, however, that business risk may not work like that. He wrote an interesting book in 1921, where he talked about the difference between risk and uncertainty. While risk is quantifiable, as in the playing of roulette, uncertainty is not quantifiable. The number of variables inherent in business means that it is almost impossible to scientifically calculate your percentage of success or failure. Therefore, instead of risk, which can be calculated, we are left with uncertainty, which cannot be calculated. In other words, rather than a simple probability, business uncertainty is as complex as an astrophysics calculation, and risk is why at least some profits are needed to overcome that risk of failure.
It is often the case, then, that business tends to compensate for that uncertainty with a relatively high level of profit. You might even think that given the probabilities for failure, business profits are too high; yet because there is a certain amount of uncertainty involved, those extra profits may be normal. Although, sometimes business profits can be excessive; therefore, competition comes into play, where the competitive forces put downward pressure on prices and profits.
Take the case of Enron. Back in the 1990s, Enron was ranked as one of the highest quality employers and most innovative companies. For example, it created new ways of conducting commodity, natural gas and credit trading, including trading on electric power markets which was considered a necessity for the success of power deregulation. Since electricity cannot be stored and markets were being set up to buy and sell electricity instantaneously, then a derivative of a future power purchase or sale could, theoretically, smooth-out the power market. Enron even put together weather derivatives where someone could obtain a kind of insurance policy for when weather related events occurred, such as a lack of rain for hydroelectric dams causing brownouts.
While many look at Enron as only a corrupt company, in fact it did innovate on a number of levels. Unfortunately, when the risky ventures did not work, the company kept doubling down, increasing its losses and debts that it also hid. The company and its investors were innovative, but got into a lot of uncertainty and lost money. All the high tech energy derivatives and all the cost effectiveness were gone. Maybe Enron was trying to push the limits of technology or maybe it was pushing the line of their own hubris, or maybe even Enron shows what the price of capitalism is: some innovations and some failures. At the end of the day, there will always be some amount of uncertainty in business and those who successfully push through it are rewarded.
Doug Reynolds is a professor of economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at email@example.com. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.