This article will help you to learn about the difference between risk bearing and uncertainty bearing nature of the firm.
Difference between Risk Bearing and Uncertainty Bearing
The two terms ‘risk’ and ‘uncertainty’ are often used interchangeably to refer to a situation of potential loss of the firm’s investment resulting from the fact that it is operating in an uncertain business environment. Risk bearing refers to having or sharing responsibility for accepting the losses if projects go wrong.
Most economic activities are capable of resulting in losses under some circumstances, however good the expected results may be. Somebody has to bear the risk of meeting any losses. The first risk-bearer for any project is the entrepreneur in a private firm, or the equity shareholders in a company.
If the losses are sufficiently large, other people connected with a firm are also at risk, including creditors, the tax authorities, customers who have paid deposits on goods to be delivered later, and workers left unpaid when a business collapses.
Certain risks are insurable (for example, the risks of fire or theft of the firm’s stock), but not the firm’s ability to survive and prosper. The firm itself must assume the risks of the market place. If it cannot sell its products it will go bankrupt; if it is successful it will make profits. Thus, risk-taking is to be viewed as an integral part of the process of supplying goods and services and in developing new products. Profits, in part, are a reward for successful risk-taking.
Since managers do not know for certain what the future holds, they are forced to guess what the most likely outcome of any decision will be, effectively assigning a statistical profitability to the likelihood of future events occurring. All such estimates of the likelihood of future events occurring must, by their very nature, be subjective, though some estimates are likely to be better than others depending upon the amount of information available.
Where large amounts of information are available upon which to base estimates of likelihood, so that accurate statistical probabilities can be formulated, we may talk of risk rather than uncertainty. For example, an insurance company dealing with fire insurance policies and claims for large number of fires and the amount of damage done by each, and can use this information to predict the likelihood of a business experiencing a fire.
This detailed statistical information allows the insurance company to charge manufacturers premium for indemnifying them against fire losses and to make a profit by so doing. By contrast, a single manufacturer would find it very difficult to predict the likelihood of his premises being damaged by fire and the amount of damage, since such an event would tend to be a unique experience for him.
Faced with a possibility of fire, the manufacturer can either choose to bear the risk of losses resulting from a serious fire or can avoid the risk of fire damage by paying an insurance company a premium to bear the risk. Again, the manufacturer can take the risk that the prices of its main raw materials will be much higher next year, or it can enter into a contract now to buy raw materials in future at a price fixed today.
Uncertainty, unlike risk, arises from changes which are difficult to predict or from events whose likelihood cannot be accurately estimated. Uncertainty refers to lack of knowledge or information about present facts or future possibilities uncertainty arises mainly due to unpredictability of future events. There is a difference between risk and uncertainty.
Risk covers cases where while individual events are not known, people believe that they know the frequency with which an event occurs (or is likely to occur). But uncertainty exists where such beliefs are absent. Events of the type covered by risk, such as individual deaths, fires, or motor accidents, are potentially insurable, while events of the types covered by uncertainty are not.
Unfortunately, most management decisions are taken under uncertain conditions, since they are rarely repetitive in nature and there is little past data available to act as a guide to the future. Such market uncertainty as to the likelihood and extent of losses which might arise in launching a new product can only be assessed by managers through combining the limited data which is available with their own judgment and experience.
Managers can improve upon their subjective estimates about the future by collecting information from forecasts, market research, feasibility studies, etc., but they need to balance the cost of collecting such information against its value in improving decisions. Where such information costs are prohibitive, managers may turn to various rules of thumb like full-cost pricing which give reasonably good (though not optimum) decisions.
The traditional theory of the firm envisaged a firm armed with perfect knowledge about its future costs and revenues, making pricing and output decisions on the basis of a marginal weighting of costs and revenues. This cognitive assumption of perfect knowledge is open to criticism for various reasons.
The entrepreneur has to take risks. The entrepreneur must risk his capital in carrying out production in anticipation of a successful outcome — he cannot guarantee success, neither can he insure against the risks of failure. Profit is usually defined as a reward for bearing the burden of uncertainty, or as a return to the function of risk-bearing.
The risks incurred in running a business are of many kinds. Some of these, such as the risk of loss due to flood, fire, or theft, or injuries to employees, are insurable, because the laws of probability can be applied to such events and insurance companies can calculate the degree of risk involved.
But no statistician can calculate the numerical probability that a firm, or group of firms, will make profits or losses in the future. Economic conditions are changing all the time and the success or failure of a particular enterprise in the past is no good guide as to the likely success or failure of a similar enterprise in the future. Profits, then, are the reward for taking non-insurable risks.