Compensating risk-taking

At a given moment, Alice has more resources than she needs. She can put that surplus – her capital – at Brian’s disposal: Brian has a current use for it. As a society, we’ve agreed that it’s right and proper for Brian to compensate Alice for that service, over and above just returning her resources to her at a later date. The justification for this compensation – the capital return – is that Alice may need the resources in the future, but Brian may or may not be able to return them to her. Or maybe he won’t be willing. Either way, Alice is uncertain about whether she will get back the resources she’s allowed Brian to use: She faces risk, and as a society we have agreed that she should be compensated for taking that risk.

This agreement is how we currently organize our economic relations. Obviously, there are very many other dimensions and complexities to the picture. But this connection between risk and reward lies at the heart of how we create and share resources with each other.

We take the relationship of risk and reward and the capital return for granted to such a degree that we overlook some puzzles it poses. My next Ruminathans will pick apart a few of them. One future post will probably have to disentangle the main forms of the capital return: profit, interest, and rent. But for now, I want to look closely at one dimension of risk/reward through the lens of the capital return we call “profit.”

Pretty much everything we value needs time, effort, and skill to acquire. Even picking up a freshly fallen apple takes a second and the effort of bending over and lifting. Not to mention the easily taken for granted knowledge that an apple is good to eat, when it is best to eat, etc., knowledge which again would have taken time and effort to acquire. But in addition to time, effort, and skill, producing goods requires a pre-existing stock of resources: If nothing else, you need to already have not just food in the belly to have the energy to work, but a belly to begin with. You start life with a physical endowment from your parents, and continue with endowments of various types, including knowledge and tools. Between generations, we “compensate” those who pass on the endowment mainly by paying it forward, but also by taking care of the aged.

Endowments can be made available not only intergenerationally but between unrelated people. And thanks to an endowment, the person receiving it may be able to produce more resources than just what she requires to survive. If Alice has a nice harpoon, she can make it available to Brian who can use it to hunt more food than he needs: That surplus can be shared back with Alice. The premise of the institution of profit is that all of the surplus of food over and above what Brian needs to survive belongs to Alice: She has a moral claim to it, a claim that Alice and Brian’s society will uphold, through enforcement of contract law, using violence if necessary.

Clearly, a lot hinges on what society considers an acceptable level of Brian’s needs. Brian will point out that he has to not only feed himself but also his family. That while he is harpooning, he cannot find wood for shelter and heat, so he needs to trade some seals for other items, which means he also has to find people to trade with and convince them that his seal meat is fresher than other hunters’. That he also needs to spend time and resources to maintain the harpoon or replace it if it breaks. And finally, while it’s not specifically necessary, he could spend some time thinking about better harpoon design and hunting methods. During that time, he still needs to be fed, but based on his reflections and experiments he may actually be able to come up with a hunting process that generates an even bigger surplus for Alice in the future. Brian’s “needs” really include the full range of accounting expense items in an income statement: cost of goods, sales and administrative expenses, depreciation, and even R&D. Sure, Alice can have whatever is left after Brian’s needs have been met. But will there be anything? Will Brian succeed in hunting more than he needs? Will he define his needs “reasonably” in some sense, or will he interpret his needs in a way that leaves nothing left for Alice? Or will he simply stop working when his own needs are met?

This is the risk Alice faces, the risk for which she expects a reward, which we as a society believe she ought to get.

Now here comes the puzzle: By using the word “ought” I have slyly reinforced an assumption that I built in at the outset, namely that this is a moral issue: that Alice has a moral claim on the surplus Brian generates. But isn’t it also part of our current collective agreement on how to share resources that we all do so freely, and negotiate whatever contract terms we want? Alice could act as a non-profit, demand no capital return, and hence also have no moral claim to one. Under the terms of the free market it is not that the provider of capital ought to be compensated for the risk she takes, but that, de facto, rational actors will only enter into agreements in which risk is compensated. Over time, people with capital (capitalists!) who do not negotiate that compensation will cease to have capital, which prevents them from making endowments in the future and may make them dependent on others’ endowments. Only those who get compensated for the risk they’ve taken will, on balance, cover the risks they take. It isn’t that Alice deserves a reward, it’s that she will only agree to make her harpoon available if she gets one. Morality has nothing to do with it.

That is the conclusion I arrived at some years ago. But in the meantime, I’ve decided that this argument is pure sophistry. Alice and Brian, capital and labor, are indeed in constant negotiations, and not just between each other but within the wider web of interaction we call society. In a negotiation, both sides make arguments to each other about what is right and proper, what is fair. In doing so they explicitly or implicitly draw on community standards of fairness. The most strident articulation of the owner’s claim on profits is Milton Friedman’s famous “the social responsibility of a business is to increase its profits.” Friedman’s is a statement about what is right and proper: a moral injunction, plain and simple.

As we negotiate, we make appeals to our partners’ sense of fairness and to what the wider community regards as fair. And, of course, the results of our negotiations also re-calibrate the community’s sense of fairness. A string of contracts that work in labor’s favor establish that as the new standard, and vice versa.

“You don’t get what you’re worth, you get what you negotiate,” the ads in the in-flight magazines tell us. But we stake out ideas about what we deserve as part of our negotiation position. I see no way around this fact. So we may as well take it as a starting point. That means debating in good faith about whether taking risks deserves compensation, which risks deserve compensation, and who is actually taking the larger risks in the capital-labor relationship.