Risk and Reward

On my old blog I took a lengthy look at the economics of why oil company profits rise when gas prices rise.  The answer was basic economics, related to the fact that oil (and one of its principle products, gasoline) is an inelastic product – meaning that the demand for the product is relatively insensitive to the price of the product (at least in the short term).  As I noted, if I burn a gallon of gas going to and from work, then regardless of the price of that gas, I’m going to need to burn that gallon regardless.  There is only so much I can do to reduce my use.

This is a second public look at economics, both to make people think, and – I hope – to show that I’m not just another pretty engineering face, but that I have multiple interests and depth beyond formulae and CAD work.

So.  Let’s play a game.  Step right up, folks, pay a dollar, roll a die, and… if it is 1-5, I keep your dollar.  If a 6, you get your dollar back.  Not interested, you say?  How about two dollars?  No?  Doing the math out, just to break even, you’d need to get five dollars.  (Math: -$1 * 5/6 = $X * 1/6; X = 5).  But nobody does games to break even.  One wants to come out ahead.  So what’s worth your time?  Six dollars?  Seven?  Ten?  This will, of course, be personal preference, but clearly nobody except a sucker is going to play at break-even payouts, let alone at a long-term loss (casinos are a notable exception; on my few visits I always budget to lose $X as my “entertainment fee” – I never think I’ll actually come out ahead).  For the sake of argument, you want the chance to double your money vs. breaking even, so $10 is the payout.

Let’s multiply everything by 10.  You pay $10, etc.  Still willing to play?  Probably.  How about by another ten.  Now you’re shelling out $100 just for the chance.  The payoff percentages are the same, the potential payback ratio is the same… but $100 is “real money”.  At $1000 people will understandably shy away.  And what if, despite a 2:1 payoff, the amount required to play is $10K?  $100K?  The number of willing players grows thin.

So what about a 10:1 payoff, or perhaps 20:1?  More people will be interested.  30:1?  Even better.  So let’s go long: 50:1.  You pay me $100K for the privilege of rolling the die, and if you win, you get $5 million.  Even at $100K a try, for a potential payout that large, I’m sure I’d have takers.  But what if I told you that after rolling the die, you then had to wait for 12 hours before I told you if you won?  Sitting there, not doing anything else?  Your time has value too, of course.  What about a week?  A year?  Do I need to go even higher on the payout ratio?  Probably so.  Even so, it’s money – nothing truly dire.

So let’s change the game.  Instead of a die… you spin the cylinder of a good old-fashioned six shooter with five bullets loaded.  Still interested?  No sane person would be, of course.  Although I’d wager if I raised the payout to, say, $1 billion I’d find a taker or two.

What’s are my points with these?  That the willingness to take a risk depends on multiple factors:

  1. The magnitude of the risk taken
  2. The consequence of the risk
  3. The ratio of the reward to the investment
  4. How long you need to wait to find out if you won

But even so, you – as the participant in all this – know the background and big picture of all this.  Suppose someone walks by just as I’m handing you that wad of cash.  And says it’s “unfair” and that you need to cough some of that money up.  Your “fair share”.  Or else, they say, tapping under their jacket to where you can see a bulging holster.

I assume you see where I’m headed with this.

Small businesses are often claimed to account for the majority of new jobs created, and the risk of failure is immense.  People stake untold hours in their start-up business, seeing countless dollars disappear not only in the cash burn but in the opportunity costs of a forsaken career working for someone else.  A joke I cite to people who run their own businesses, with an approving head-nod: “As a small business owner, you get to work half days; you choose which 12 hours you want.”  (Shameless plug for my friend Greg, who makes pet products and is trying to build up his business.)  People can leverage every dime they have, mortgaging their homes, raiding their savings and even retirement funds.  The financial and emotional risks are immense.  Marriages can crack and sunder under the strain of untold hours spent at the business, the emotional investment, and the financial risks taken.

So let me get specific.  Lower tax rates spur job growth for two reasons:

  1. A lower tax rate increases the reward for a given level of risk; if a person was not willing to take a chance at a 10:1 in-their-pocket payoff, they may be willing to do so for a 15:1 payoff.  More people taking the chance of starting a business, statistically, means more businesses launched and – through sheer numbers – more jobs created.
  2. A lower tax rate on those who already have money means more money invested in venture capital and angel funds.  These monies go to support promising start-ups that, if successful, will create more jobs.

This is not a partisan issue; I am not advocating this because of a love affair with the GOP, or a hatred of the Democrats – indeed, of advocacy or opposition to any particular political creed.  I want to do what works to grow the economy, and believe that I have demonstrated what I believe will work through argument and example.  If you disagree, please tell me where I’m wrong.  No flaming please.

© 2013, David Hunt, PE

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