Risks and Uncertainty

The Difference Between Risk and Uncertainty

No firm knows for sure how a decision will turn out. Economists split that unknown into two kinds.

Risk: an unknown outcome whose chances can be measured, usually from past data, so a probability can be put on it.

Uncertainty: an unknown outcome whose chances cannot be measured, because there is no past record to go on.

A haulage firm cannot know which lorry will crash next year, but records across thousands of lorries show roughly how many will. That is a risk. Whether a new rival will open next door, or a new product will sell, has no such record. That is uncertainty.

The difference matters because of what a firm can do about it:

• Risk can be priced: it can be measured → an insurer or a bank can work out a fair charge for taking it on → the firm swaps an unknown loss for a known cost, such as an insurance premium.
• Uncertainty cannot: no one can put a number on it → no one will sell cover against it → the owners carry it themselves. Profit is their reward for doing so.

The Impact of Shocks

Economic shock: an unexpected event that suddenly changes demand or costs across the economy.

A demand shock changes how much customers buy, as when lockdowns closed restaurants and shops in 2020. A supply shock changes what it costs to produce, as when gas prices jumped after Russia invaded Ukraine in 2022. Shocks are a source of uncertainty: few firms see them coming.

When a negative shock hits:

• Firms facing a demand shock: sales fall suddenly → revenue drops while rent and loan repayments stay the same → cash runs short → firms cut staff, delay investment or close.
• Firms facing a supply shock: energy or materials cost more → unit costs rise → the firm raises prices and loses sales, or holds prices and accepts a lower profit margin.
• Workers and consumers: job losses and higher prices → lower real incomes → less spending, which passes the shock on to other firms.

Shocks also create winners. In 2020 online retailers and delivery firms gained as shoppers moved online, and in 2022 energy producers earned far more from higher prices.

How badly a firm is hurt depends on:

• Size and duration: a business can ride out a short shock on its savings. One that lasts years can change what customers buy for good.
• Cash reserves and debt: a firm with cash in the bank and little borrowing can wait for demand to recover. A heavily borrowed firm may run out of cash first.
• Ability to pass costs on: with price inelastic demand or a strong brand, a firm can raise prices after a supply shock and keep most of its sales.

Exchange Rate Risk and Forward Markets

Exchange rate risk: the risk that a change in the exchange rate alters the value of a payment a firm has agreed to make or receive in a foreign currency.

An importer that must pay in dollars in three months does not know what that will cost in pounds. If the pound weakens, it pays more. An exporter waiting to be paid in euros faces the reverse: a stronger pound means fewer pounds when the euros arrive.

To turn a foreign-currency amount into pounds, divide by the exchange rate: \[ \text{Amount in pounds} = \frac{\text{Amount in dollars}}{\text{Dollars per £1}} \]

Forward contract: an agreement made today to buy or sell a currency on a set future date at an exchange rate fixed now.

Banks sell forward contracts in the forward market. Using one to remove exchange rate risk is called hedging.

Hedging fixes the pound value of a deal → the firm can set prices and budget, and a sudden currency move cannot wipe out its margin → it is more willing to sign overseas deals.

Whether hedging is worth it depends on:

• Lost gains: the firm gives up any benefit from a favourable move, as the bike shop's second row shows.
• Cost and scale: banks charge for the service, so a small firm with few overseas deals may not bother.
• Known amounts and dates: a contract fixes one sum on one date. It cannot protect sales a firm has not yet won, or a fall in the pound that lasts for years.

The Role of Insurance in Business

Insurance: a contract in which a firm pays a regular sum, the premium, and the insurer agrees to pay compensation if a specified loss happens.

Insurance works by pooling risk. An insurer collects premiums from thousands of firms, knowing from past data that only a few will claim in a year. The premiums from the many pay for the losses of the few.

Firms commonly insure their buildings and stock against fire, flood and theft. Employers' liability insurance, which covers claims from injured staff, is required by law as soon as a firm takes on employees.

Insurance helps a business in three ways:

• Survival: a fire destroys a bakery's ovens → the insurer pays for new ones → the bakery reopens instead of closing, and its staff keep their jobs.
• Steady costs: a fixed premium replaces a large, unpredictable loss → cash flow is easier to forecast.
• Access to finance: banks lending against property usually insist it is insured → insurance protects their collateral → the firm can borrow.

Its limits:

• Only risks are covered: no insurer will pay out because sales fell, a rival undercut the firm or a product flopped. Those are uncertainties.
• Premiums are a cost: they rise after a claim or in high-risk areas, such as flood plains, and some firms insure for less than their assets are worth to save money.