8.08. The Entrepreneurial Component in the Market Interest Rate

0:008. The Entrepreneurial Component in the Market Interest Rate In the ERE, as we have seen, the interest rate throughout the economy will be uniform. In the real world, there is an additional entrepreneurial or risk component, which adds to the interest rate in particularly risky ventures, and in accordance with the degree of risk. Risk. Since risk has an actuarially certain connotation, we may better call it degree of uncertainty. Thus, suppose that the basic social time preference rate, or pure rate of interest in the economy, is 5%. Capitalists will buy 100 ounces of future goods to sell A 5% return is a pure return. That is, it is the return assuming that the 105 ounces will definitely be accruing.

1:09The pure rate, in other words, abstracts from any entrepreneurial uncertainty. It gauges is the premium of present over future goods on the assumption that the future goods are known as certain to be forthcoming. In the real world, of course, nothing is absolutely certain, and therefore the pure rate of interest, the result of time preference, can never appear alone. Now suppose that in one particular venture or industry it is fairly certain that 105 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.

2:01But suppose that there is another possible venture considered very risky by entrepreneurs. The product is expected to sell for 105 ounces, but there are definite possibilities that the price of the product might plummet. In that case, the entrepreneurs will not be willing to pay 100 ounces for factors. They would have to be compensated for the extra risks that they run. run. The price of the factors might finally be 90 ounces. Thus, the riskier a given venture appears ex ante, the higher will be the expected interest return that capitalists will require before they make the investment. On the market, then, a whole structure of interest rates will be superimposed on the pure rate, varying positively in accordance with the expected risks of each venture.

2:59The counterpart of this structure will be a similar variety of interest rates on the loan market, which as usual is derivative from the goods market. The loan market will diverge from the natural market to the extent that conditions for repayment of loans, etc. establish such differences. The two would be the same if the loans were clearly recognized as entrepreneurial, so So that in cases where there was no deliberate fraud, the borrower would not be considered criminal if he did not repay the loan. However, if, as discussed in Chapter 2, there are no bankruptcy laws, and defaulting borrowers are considered criminal, then obviously the safety of all loans would increase in relation to natural investments, and the interest rates on loans would decline accordingly.

3:56In the free society, however, there would be nothing to prevent borrowers and lenders from agreeing, at the time the contract is made, that borrowers would not be held criminally responsible, and that the loan would really be an entrepreneurial one, or they could make any sort of arrangement in dividing gains or losses that they might choose. In the long run, of course, the tendency, given no changes of data, will be for people It is possible to realize that such and such a venture is pretty consistently yielding a higher than 5% return. The risk component for this venture will then fall. Other entrepreneurs will enter this type of venture, and the interest rate will tend to fall back to 5% again.

4:45Thus, the varying risk structure of interest does not invalidate the tendency toward uniformity of the interest rate. And the contrary, any variety is something of an index of the various risks of uncertainty which still remain in the market, and which would be eliminated if data were frozen and an ERE were reached. If data did remain constant, then the uniformity of the ERE would ensue. It is because data are always changing, and thus setting up new uncertainties in place Entrepreneurship deals with the inevitable uncertainty of the future.

5:41Some forms of uncertainty, however, can be converted into actuarial risk. The distinction between risk and uncertainty has been developed by Professor Knight. 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. 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%. It will not know whether any given bolt will be defective, but it will know the proportion of the total number defective.

6:29This knowledge can convert the percentage of defects into a definite cost of the firm's operations, especially where enough cases occur within a firm. In other situations, a given loss or hazard may be large and infrequent in relation to to a firm's operations, such as the risk of fire, but over a large number of firms it could be considered as a measurable or actuarial risk. In such situations the firms themselves could pool their risks, or a specialized firm, an insurance company, could organize the pooling for them. The principle of insurance is that firms or individuals are subject to risks which, in In the aggregate, form a class of homogeneous cases.

7:21Thus, out of a class of a thousand firms, no one firm has any idea whether it will suffer a fire next year or not. But it is fairly well known that ten of them will. In that case, it may be advantageous for each of the firms to take out insurance, to pool their risks of loss. Each firm will pay a certain premium which will go into a pool to compensate those firms which suffer the fires. As a result of competition, the firm organizing the insurance service will tend to obtain the usual interest income on its investment, no more and no less. The contrast between risk and uncertainty has been brilliantly analyzed by Ludwig von Mises.

8:12Mises has shown that they can be subsumed under the more general categories of class probability and case probability. Class probability is the only scientific use of the term probability, and is the only form of probability subject to numerical expression. In the tangled literature on probability, no one has defined class probability as cogently as Ludwig von Mises. Class probability means, we know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena. But about the actual singular events or phenomena, we know nothing but that they are elements of this class.

9:04Insurable risk is an example of class probability. The businessman knew how many bolts would be defective out of a total number of bolts, but had no knowledge as to which particular bolts would be defective. In life insurance, the mortality tables reveal the proportion of mortality of each age group in the population, but they tell nothing about the particular life expectancy of any given individual. 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.

10:01Thus, certain subgroups within one age group may have a higher mortality rate because of their occupation. These will be segregated, and different premiums applied to the two cases. If there were knowledge about differences between subgroups and insurance firms charged the same premium rate to all, then this would mean that the healthy or less risky groups would be subsidizing the riskier. Unless they specifically desire to grant such subsidies, this result will never be maintained in the competitive free market. In the free market, each homogeneous group will tend to pay premium rates in proportion to its actuarial risk, plus a sum for interest income and for necessary costs for the insurance firms.

10:55Most uncertainties are uninsurable, because they are unique, single cases, and not members of a class. They are unique cases facing each individual or business. They may bear resemblances to other cases, but are not homogeneous with them. Individuals or entrepreneurs know something about the outcome of the particular case, but not everything. As Mises defines it, case probability means we know with regard to a particular event some of the factors which determine its outcome, but there are other determining factors about which we know nothing. Estimates of future costs, demands, etc. on the part of entrepreneurs are all unique cases Methods of Uncertainty, where methods of specific understanding and individual judgment of the situation must apply, rather than objectively measurable or insurable risk.

12:00It is not accurate to apply terms like gambling or betting to situations either of risk or of uncertainty. These terms have unfavorable emotional implications, and for this reason, they refer to situations where new risks or uncertainties are created for the enjoyment of the uncertainties themselves. Gambling on the throw of the dice and betting on horse races are examples of the deliberate creation by the better or gambler of new uncertainties which otherwise would not have existed. There is a distinction between gambling and betting. Gambling refers to wagering on events of class probability, such as throws of dice, where there is no knowledge of the unique event.

12:54Betting refers to wagering on a unique event about which both parties to the bet know something, such as a horse race or a presidential election. In either case, however, the wagerer is creating a new risk or uncertainty. The entrepreneur, on the other hand, is not creating uncertainties for the fun of it. On the contrary, he tries to reduce them as much as possible. The uncertainties he confronts are already inherent in the market situation. Indeed, in the nature of human action, someone must deal with them, and he is the most skilled Profit and Loss are the results of entrepreneurial uncertainty, actuarial risk is converted into to a cost of business operation, and is not responsible for profits or losses except insofar as the actuarial estimates are erroneous.