WEBVTT NOTE 8.08. The Entrepreneurial Component in the Market Interest Rate 1 00:00:00.000 --> 00:00:06.000 8. The Entrepreneurial Component in the Market Interest Rate 2 00:00:06.000 --> 00:00:13.000 In the ERE, as we have seen, the interest rate throughout the economy will be uniform. 3 00:00:13.000 --> 00:00:19.000 In the real world, there is an additional entrepreneurial or risk component, 4 00:00:19.000 --> 00:00:24.000 which adds to the interest rate in particularly risky ventures, 5 00:00:24.000 --> 00:00:27.000 and in accordance with the degree of risk. 6 00:00:27.000 --> 00:00:34.620 Risk. Since risk has an actuarially certain connotation, we may better call it degree 7 00:00:34.620 --> 00:00:41.760 of uncertainty. Thus, suppose that the basic social time preference rate, or pure rate 8 00:00:41.760 --> 00:00:50.240 of interest in the economy, is 5%. Capitalists will buy 100 ounces of future goods to sell 9 00:00:50.240 --> 00:00:57.240 A 5% return is a pure return. That is, it is the return assuming that the 105 ounces will definitely be accruing. 10 00:01:09.000 --> 00:01:15.640 The pure rate, in other words, abstracts from any entrepreneurial uncertainty. It gauges 11 00:01:15.640 --> 00:01:21.360 is the premium of present over future goods on the assumption that the future goods are 12 00:01:21.360 --> 00:01:25.540 known as certain to be forthcoming. 13 00:01:25.540 --> 00:01:32.400 In the real world, of course, nothing is absolutely certain, and therefore the pure rate of interest, 14 00:01:32.400 --> 00:01:36.840 the result of time preference, can never appear alone. 15 00:01:36.840 --> 00:01:43.880 Now suppose that in one particular venture or industry it is fairly certain that 105 16 00:01:43.880 --> 00:02:01.880 will be earned from the sale of a product one year in the future, then with a social time preference rate of 5%, the capitalist entrepreneurs will be willing to pay 100 ounces for factors and reap a 5% return. 17 00:02:01.880 --> 00:02:08.880 But suppose that there is another possible venture considered very risky by entrepreneurs. 18 00:02:08.880 --> 00:02:17.880 The product is expected to sell for 105 ounces, but there are definite possibilities that the price of the product might plummet. 19 00:02:17.880 --> 00:02:24.880 In that case, the entrepreneurs will not be willing to pay 100 ounces for factors. 20 00:02:24.880 --> 00:02:28.880 They would have to be compensated for the extra risks that they run. 21 00:02:28.880 --> 00:02:35.680 run. The price of the factors might finally be 90 ounces. Thus, the riskier a given venture 22 00:02:35.680 --> 00:02:43.360 appears ex ante, the higher will be the expected interest return that capitalists will require 23 00:02:43.360 --> 00:02:49.960 before they make the investment. On the market, then, a whole structure of interest rates 24 00:02:49.960 --> 00:02:56.800 will be superimposed on the pure rate, varying positively in accordance with the expected 25 00:02:56.800 --> 00:02:59.160 risks of each venture. 26 00:02:59.160 --> 00:03:04.320 The counterpart of this structure will be a similar variety of interest rates on the 27 00:03:04.320 --> 00:03:09.960 loan market, which as usual is derivative from the goods market. 28 00:03:09.960 --> 00:03:16.280 The loan market will diverge from the natural market to the extent that conditions for repayment 29 00:03:16.280 --> 00:03:20.640 of loans, etc. establish such differences. 30 00:03:20.640 --> 00:03:26.500 The two would be the same if the loans were clearly recognized as entrepreneurial, so 31 00:03:26.500 --> 00:03:32.060 So that in cases where there was no deliberate fraud, the borrower would not be considered 32 00:03:32.060 --> 00:03:35.260 criminal if he did not repay the loan. 33 00:03:35.260 --> 00:03:42.500 However, if, as discussed in Chapter 2, there are no bankruptcy laws, and defaulting borrowers 34 00:03:42.500 --> 00:03:49.460 are considered criminal, then obviously the safety of all loans would increase in relation 35 00:03:49.460 --> 00:03:56.000 to natural investments, and the interest rates on loans would decline accordingly. 36 00:03:56.000 --> 00:04:01.000 In the free society, however, there would be nothing to prevent borrowers and lenders 37 00:04:01.000 --> 00:04:07.960 from agreeing, at the time the contract is made, that borrowers would not be held criminally 38 00:04:07.960 --> 00:04:14.120 responsible, and that the loan would really be an entrepreneurial one, or they could make 39 00:04:14.120 --> 00:04:19.740 any sort of arrangement in dividing gains or losses that they might choose. 40 00:04:19.740 --> 00:04:25.660 In the long run, of course, the tendency, given no changes of data, will be for people 41 00:04:25.660 --> 00:04:33.660 It is possible to realize that such and such a venture is pretty consistently yielding a higher than 5% return. 42 00:04:33.660 --> 00:04:37.660 The risk component for this venture will then fall. 43 00:04:37.660 --> 00:04:45.660 Other entrepreneurs will enter this type of venture, and the interest rate will tend to fall back to 5% again. 44 00:04:45.660 --> 00:04:54.660 Thus, the varying risk structure of interest does not invalidate the tendency toward uniformity of the interest rate. 45 00:04:54.660 --> 00:05:01.660 And the contrary, any variety is something of an index of the various risks of uncertainty 46 00:05:01.660 --> 00:05:08.220 which still remain in the market, and which would be eliminated if data were frozen and 47 00:05:08.220 --> 00:05:11.020 an ERE were reached. 48 00:05:11.020 --> 00:05:17.700 If data did remain constant, then the uniformity of the ERE would ensue. 49 00:05:17.700 --> 00:05:24.200 It is because data are always changing, and thus setting up new uncertainties in place 50 00:05:24.200 --> 00:05:41.440 Entrepreneurship deals with the inevitable uncertainty of the future. 51 00:05:41.440 --> 00:05:47.600 Some forms of uncertainty, however, can be converted into actuarial risk. 52 00:05:47.600 --> 00:05:54.160 The distinction between risk and uncertainty has been developed by Professor Knight. 53 00:05:54.160 --> 00:06:07.160 A risk occurs when an event is a member of a class of a large number of homogeneous events and there is fairly certain knowledge of the frequency of occurrence of this class of events. 54 00:06:07.160 --> 00:06:20.160 Thus, a firm may produce bolts and know from long experience that a certain almost fixed proportion of these bolts will be defective, say 1%. 55 00:06:20.160 --> 00:06:26.280 It will not know whether any given bolt will be defective, but it will know the proportion 56 00:06:26.280 --> 00:06:29.280 of the total number defective. 57 00:06:29.280 --> 00:06:35.600 This knowledge can convert the percentage of defects into a definite cost of the firm's 58 00:06:35.600 --> 00:06:40.960 operations, especially where enough cases occur within a firm. 59 00:06:40.960 --> 00:06:47.580 In other situations, a given loss or hazard may be large and infrequent in relation to 60 00:06:47.580 --> 00:06:53.980 to a firm's operations, such as the risk of fire, but over a large number of firms it 61 00:06:53.980 --> 00:06:59.260 could be considered as a measurable or actuarial risk. 62 00:06:59.260 --> 00:07:06.220 In such situations the firms themselves could pool their risks, or a specialized firm, an 63 00:07:06.220 --> 00:07:10.980 insurance company, could organize the pooling for them. 64 00:07:10.980 --> 00:07:17.180 The principle of insurance is that firms or individuals are subject to risks which, in 65 00:07:17.180 --> 00:07:21.420 In the aggregate, form a class of homogeneous cases. 66 00:07:21.420 --> 00:07:28.540 Thus, out of a class of a thousand firms, no one firm has any idea whether it will suffer 67 00:07:28.540 --> 00:07:31.340 a fire next year or not. 68 00:07:31.340 --> 00:07:35.340 But it is fairly well known that ten of them will. 69 00:07:35.340 --> 00:07:41.860 In that case, it may be advantageous for each of the firms to take out insurance, to pool 70 00:07:41.860 --> 00:07:44.180 their risks of loss. 71 00:07:44.180 --> 00:07:50.220 Each firm will pay a certain premium which will go into a pool to compensate those firms 72 00:07:50.220 --> 00:07:53.140 which suffer the fires. 73 00:07:53.140 --> 00:07:58.980 As a result of competition, the firm organizing the insurance service will tend to obtain 74 00:07:58.980 --> 00:08:05.700 the usual interest income on its investment, no more and no less. 75 00:08:05.700 --> 00:08:11.380 The contrast between risk and uncertainty has been brilliantly analyzed by Ludwig von 76 00:08:11.380 --> 00:08:12.380 Mises. 77 00:08:12.380 --> 00:08:21.880 Mises has shown that they can be subsumed under the more general categories of class probability and case probability. 78 00:08:21.880 --> 00:08:27.880 Class probability is the only scientific use of the term probability, 79 00:08:27.880 --> 00:08:33.380 and is the only form of probability subject to numerical expression. 80 00:08:33.380 --> 00:08:42.280 In the tangled literature on probability, no one has defined class probability as cogently as Ludwig von Mises. 81 00:08:42.280 --> 00:08:49.780 Class probability means, we know or assume to know, with regard to the problem concerned, 82 00:08:49.780 --> 00:08:55.480 everything about the behavior of a whole class of events or phenomena. 83 00:08:55.480 --> 00:09:04.980 But about the actual singular events or phenomena, we know nothing but that they are elements of this class. 84 00:09:04.980 --> 00:09:09.680 Insurable risk is an example of class probability. 85 00:09:09.680 --> 00:09:16.080 The businessman knew how many bolts would be defective out of a total number of bolts, 86 00:09:16.080 --> 00:09:21.440 but had no knowledge as to which particular bolts would be defective. 87 00:09:21.440 --> 00:09:28.880 In life insurance, the mortality tables reveal the proportion of mortality of each age group in the 88 00:09:28.880 --> 00:09:35.520 population, but they tell nothing about the particular life expectancy of any given individual. 89 00:09:35.520 --> 00:10:01.520 Insurance firms have their problems. As soon as something specific is known about individual cases, firms break down the cases into sub-aggregates in an effort to maintain homogeneity of classes, that is, the similarity, as far as is known, of all individual members in the class with respect to the attribute in question. 90 00:10:01.520 --> 00:10:08.600 Thus, certain subgroups within one age group may have a higher mortality rate because of 91 00:10:08.600 --> 00:10:10.480 their occupation. 92 00:10:10.480 --> 00:10:15.820 These will be segregated, and different premiums applied to the two cases. 93 00:10:15.820 --> 00:10:21.320 If there were knowledge about differences between subgroups and insurance firms charged 94 00:10:21.320 --> 00:10:28.120 the same premium rate to all, then this would mean that the healthy or less risky groups 95 00:10:28.120 --> 00:10:31.160 would be subsidizing the riskier. 96 00:10:31.160 --> 00:10:37.340 Unless they specifically desire to grant such subsidies, this result will never be maintained 97 00:10:37.340 --> 00:10:39.840 in the competitive free market. 98 00:10:39.840 --> 00:10:46.000 In the free market, each homogeneous group will tend to pay premium rates in proportion 99 00:10:46.000 --> 00:10:54.040 to its actuarial risk, plus a sum for interest income and for necessary costs for the insurance 100 00:10:54.040 --> 00:10:55.960 firms. 101 00:10:55.960 --> 00:11:02.680 Most uncertainties are uninsurable, because they are unique, single cases, and not members 102 00:11:02.680 --> 00:11:04.020 of a class. 103 00:11:04.020 --> 00:11:08.760 They are unique cases facing each individual or business. 104 00:11:08.760 --> 00:11:15.320 They may bear resemblances to other cases, but are not homogeneous with them. 105 00:11:15.320 --> 00:11:20.920 Individuals or entrepreneurs know something about the outcome of the particular case, 106 00:11:20.920 --> 00:11:22.540 but not everything. 107 00:11:22.540 --> 00:11:29.700 As Mises defines it, case probability means we know with regard to a particular event 108 00:11:29.700 --> 00:11:35.980 some of the factors which determine its outcome, but there are other determining factors about 109 00:11:35.980 --> 00:11:38.540 which we know nothing. 110 00:11:38.540 --> 00:11:45.720 Estimates of future costs, demands, etc. on the part of entrepreneurs are all unique cases 111 00:11:45.720 --> 00:11:51.880 Methods of Uncertainty, where methods of specific understanding and individual judgment 112 00:11:51.880 --> 00:12:00.620 of the situation must apply, rather than objectively measurable or insurable risk. 113 00:12:00.620 --> 00:12:08.220 It is not accurate to apply terms like gambling or betting to situations either of risk or 114 00:12:08.220 --> 00:12:10.060 of uncertainty. 115 00:12:10.060 --> 00:12:17.000 These terms have unfavorable emotional implications, and for this reason, they refer to situations 116 00:12:17.000 --> 00:12:26.480 where new risks or uncertainties are created for the enjoyment of the uncertainties themselves. 117 00:12:26.480 --> 00:12:32.200 Gambling on the throw of the dice and betting on horse races are examples of the deliberate 118 00:12:32.200 --> 00:12:40.040 creation by the better or gambler of new uncertainties which otherwise would not have existed. 119 00:12:40.040 --> 00:12:44.160 There is a distinction between gambling and betting. 120 00:12:44.160 --> 00:12:50.720 Gambling refers to wagering on events of class probability, such as throws of dice, where 121 00:12:50.720 --> 00:12:54.480 there is no knowledge of the unique event. 122 00:12:54.480 --> 00:13:02.480 Betting refers to wagering on a unique event about which both parties to the bet know something, 123 00:13:02.480 --> 00:13:06.000 such as a horse race or a presidential election. 124 00:13:06.000 --> 00:13:13.020 In either case, however, the wagerer is creating a new risk or uncertainty. 125 00:13:13.020 --> 00:13:18.780 The entrepreneur, on the other hand, is not creating uncertainties for the fun of it. 126 00:13:18.780 --> 00:13:23.200 On the contrary, he tries to reduce them as much as possible. 127 00:13:23.200 --> 00:13:28.560 The uncertainties he confronts are already inherent in the market situation. 128 00:13:28.560 --> 00:13:35.360 Indeed, in the nature of human action, someone must deal with them, and he is the most skilled 129 00:13:35.360 --> 00:14:02.880 Profit and Loss are the results of entrepreneurial uncertainty, actuarial risk is converted into 130 00:14:02.880 --> 00:14:10.600 to a cost of business operation, and is not responsible for profits or losses except insofar 131 00:14:10.600 --> 00:14:14.160 as the actuarial estimates are erroneous.