Business Risk: The First Systematic Studies on Risk and on Uncertainty in Economic Theory

Abstract

In recent years, in the internationally, there has been considerable interest in the management and governance of business risks. At the base of the growing interest of scholars and operators – especially of Anglo-Saxon origin – in the risk analysis are found, on the one hand, in the weight that risk has assumed in strategic decisions and, on the other, in the growing difficulty of risk assessment same. Currently, the issue of risk has taken on a rather important role in the company, in all its many components. In fact, we encounter a vast variety of risky events with which the company has to live daily and which go to invest all company sectors: marketing, corporate investments, etc. This work focuses on the first systematic studies on risk and Risk and uncertainty in economic theory.

Keywords: Risk; Systematic studies on risk; Risk and uncertainty in economic theory.

Introduction

It is impossible to find natural activity or human behaviour that is not characterized by the presence, contemporary or otherwise, of uncertainty and risk. Only pure sciences, such as mathematics and logic, are not confronted with the empirical dimension and are governed by strict rules of pure determinism and deductive logic. In particular, in the economic disciplines the importance of the concept of risk has grown dramatically in recent decades due to the rapidity of changes in the operational contexts in which many companies operate. An evolution has been observed from a static frame of reference – based on determinism – to theoretical settings in which the component variables in any model are conditioned and interacted dynamically. This evolution originated from positions in which the concepts of uncertainty and risk had no place and had no meaning: the variables were used in a static way and any modification, if any, was governed by mechanistic laws, defined a priori, which they brought the system into balance. Therefore, in these situations, every change was perfectly predictable a priori, once the determinant or factors governing it had been identified. This means that once an event A (the cause) has occurred, it follows that, in a necessary way, there is the manifestation of event B (the effect). This process of evolution has led to theoretical approaches in which the main characterization is the concept of dynamism: balance is no longer obtained or interpreted in a static way, but on the contrary, through a logic of evolution of the overall system. A theoretical approach, which breaks with the classic pattern of static, is that in which entrepreneurial activity, or rather the entrepreneurial function, begins to be characterized by the concept of uncertainty. In fact, the entrepreneurial function is identified in the innovations of knowledge aimed at the conception, preparation and implementation of new processes and production combinations. Therefore the entrepreneurial function is characterized in a very relevant way only in the case in which a dynamic reality is referred to. In fact, in such situations, the entrepreneur, through innovations within a constantly renewing context, determines the profit. This profit derives from the adoption and use of new production functions which, due to their nature of innovation within an environment that is also constantly changing, present themselves with characteristics of uncertainty and risk. This evolution has also brought within the economic disciplines the need, born from the empirical observation that many economic activities have to do with uncertainty and risk, to deal with the problem of risk analysis in companies and choice in conditions of uncertainty. The ways in which companies and individuals are faced with uncertainty and risk are manifold. In the first place, individuals and organizations relate to phenomena and events that have characteristics that are not perfectly known or predictable in their complexity and variety. Secondly, the economic operators set up strategic relationships with other subjects and companies. The effects, precisely because the relations established are of a strategic type, are not known a priori as it is not possible to hypothesize the impact on environmental states and not even the relationship behaviours of other economic agents. This means that any behaviour of an economic agent and any environmental change have an impact and an effect that are difficult to predict and consequently are of an uncertain and risky nature. In fact, it is rarely possible to assess the future consequences that an individual or a company may suffer and from which decisions and from which changes in the environmental context such consequences originated. Studies based on the corporate concept of risk move towards an analysis not of individuals but of subjects located within institutions (companies) with the aim, on the one hand, of selecting partially risky events, perceiving and hypothesizing the associated risk, and to evaluate the consequences; on the other hand, the focus is on the attempt to make explicit the link between the functions and corporate decisions and the risks associated with them and emanating from them. Therefore, the research and identification of methodologies that make it possible for the company to eliminate, reduce, transfer or assume risks appears to be significant. It appears, that is, evident that it is essential to address the problem of the concept of risk and uncertainty in relation to the organizational context of the company within which one finds oneself. Subsequently we will analyse the concept of risk and uncertainty as treated by business economics studies. The purpose of the analysis of the evolution of literature in the conception of risk and uncertainty is twofold. On the one hand, it allows us to make explicit the significant dimensions in the characterization of these concepts; on the other hand, it makes it possible to highlight how there has been a change in the object of study over time. After the analysis of the economic and economic-business settings prevailing in the definition of uncertainty and risk, the goal is to bring out how the company is closely interrelated with risk. We will try to illustrate how the economic nature of the risk derives from the very nature of the company. In fact, in the life of this company, there is no phenomenon or operation that is not relevant from an economic point of view: all directly or indirectly, tends to affect the process of generating the value of the company and its performance, in a positive or negative sense. The company is a set of coordination’s in place and all the events that concern the life of the company, whatever the original cause, sooner or later end up acquiring economic significance. Therefore, in light of the definitions of risk and uncertainty of the business economy, it will be found that even risks, despite their abstract nature and their origin, are therefore subject to this principle. In this sense, existing business processes and choices in conditions of uncertainty only acquire meaning if they are studied in relation to the constraints and opportunities that the resulting dimensions and variables offer. Based on these reflections, it seems logical to undertake a study of these variables in a budget, anticipating the real occurrence of the facts, creating possible states of the environment and adequately evaluating each final result. So much so that the study of these variables only acquires meaning if placed within a future-oriented corporate vision. In fact, addressing this analysis to the past would be useless, since it would not be in the presence of states of the environment in conditions of uncertainty, but of actual situations that have already occurred. The underlying logic that guides the development of this paragraph is to analyse the evolution of the concept of the term risk by examining the main contributions of economic theory. In business and economic studies, various approaches have been developed on this topic, each of which is different from the other for slight nuances or for concepts that completely distort the meaning it reaches. In studying the concept of risk, one of the first obstacles encountered is the presence in the literature of an abundance of meanings and definitions. Risk is one of those terms that has a myriad of definitions. There are hidden ambiguities in the notions of risk and uncertainty. These two terms are often used interchangeably, but have substantially different meanings in economic studies. The influence of the prevailing scientific paradigm is significant in these studies; therefore the theoretical positions are aimed, first of all, at identifying the causal determinants that give rise to risk and uncertainty; secondly, looking for the components and dimensions that characterize this concept.

The First Systematic Studies on Risk

Within the deterministic scientific paradigm based on the necessary randomness, we find the first systematic studies concerning risk. These first analyses partly take up considerations of an intuitive nature present in common sense. The focus is on identifying the causes and significant characteristics. Within this line of research we find the works of Gobbi, from 1974, which focus on the research of the causal determinants of uncertainty and risk. Gobbi identifies the concept of time as one of the determining factors of uncertainty. This position arises from the empirical observation of how there is always an interval between the moment in which a subject formulates expectations and the moment in which the latter manifest themselves. The centrality of the concept of time arises from the fact that, on the one hand, there is no economic act that manifests its effects immediately and, on the other hand, that such effects cannot be defined a priori as completely certain. The concept of uncertainty therefore acquires a double characterization in relation to the self an event occurs and to when it occurs. Consequently, since the future is uncertain, the outcome of each operation is subject to the rules of uncertainty in relation to the variables just illustrated. The existence of this temporal discrepancy between the moment of occurrence of the event and the manifestation of its effects is not a necessary and within the deterministic scientific paradigm based on the necessary randomness, we find the first systematic studies concerning risk. These first analyses partly take up considerations of an intuitive nature present in common sense. The focus is on identifying the causes and significant characteristics. Within this line of research we find the works of Gobbi, from 1974, which focus on the research of the causal determinants of uncertainty and risk. Gobbi identifies the concept of time as one of the determining factors of uncertainty. This position arises from the empirical observation of how there is always an interval between the moment in which a subject formulates expectations and the moment in which the latter manifest themselves. The centrality of the concept of time arises from the fact that, on the one hand, there is no economic act that manifests its effects immediately and, on the other hand, that such effects cannot be defined a priori as completely certain. The concept of uncertainty therefore acquires a double characterization in relation to the self an event occurs and to when it occurs. Consequently, since the future is uncertain, the outcome of each operation is subject to the rules of uncertainty in relation to the variables just illustrated. The existence of this temporal discrepancy between the moment of occurrence of the event and the manifestation of its effects is not a necessary and sufficient condition for us to talk about uncertainty and risk. A second factor is encountered: the lack of information relating to the occurrence of a certain event and this factor arises in relation to the ability to predict a future event. This means that if you know the moment of the occurrence of a fact, the causes that determine it and the effects it produces, you are no longer in the presence of uncertainty. In this setting, the risk is placed in close connection with the uncertainty from which it derives: in fact it is the existence of uncertainty that makes a future event not perfectly predictable and the favourable or unfavourable consequences. On the basis of these considerations it is possible to state that uncertainty and risk are characterized above all by the factor of not perfect knowledge of future states. Consequently, the existence of a perfect knowledge of the states of nature, of the causal laws that bind events would cancel out both the randomness and the risk, as every fact would become completely predictable. It therefore appears evident that an improvement in the forecasting abilities of the subjects can lead to a reduction in the level of uncertainty and therefore in the risk associated with a specific decision. According to Gobbi, it is in the differences between an unfavorable event and a favorable event that the concepts of risk and uncertainty are characterized: the events that produce favorable or independent effects are identified by the term alea; the risk, on the other hand, is closely related to the occurrence of future events that bring unfavorable consequences. On the other hand, it is always the subject who evaluates the effects generated by a fact and therefore the difference between risk and uncertainty is based on a purely subjective dimension. Questa distinzione ha avuto una forte influenza in literature e sono molte le impostazioni che basano la definizione del rischio sulla caratteristica della dualita; tra queste sono la scuola austriaca dell’Oberparleiter   e quella Italian con Sassi. By separating the objective and subjective dimension, the concepts of risk and uncertainty can be grasped, specified and differentiated; this dimension will find ample consensus and areas of application in the subsequent theoretical approaches.

Risk and Uncertainty in Economic Theory

Within the economic theory, those approaches that try to introduce the concept of risk are analysed and the problem of the definition of risk is tackled in such a way that it is consistent with the assumptions on which the reference economic model is based. Knight’s work presents itself as one of the first organic contributions dedicated to risk and uncertainty and also contains an analysis of the methodologies that can be adopted in order to perceive and measure, even if only from a logical point of view, risk and uncertainty. Most scholars agree in considering man’s limited intellectual and cognitive abilities at the basis of both risk and uncertainty. The most radical position was taken by Knight, according to whom “what we live in is a world of change and uncertainty. We live only because we know something of the future; while the problems arise from the fact that we know too little about them. There is therefore no absolute ignorance, no complete or perfect information, but partial knowledge: before reacting to the world we perceive it and react not to what we perceive, but to what we infer. Knight’s analysis therefore starts from the observation that most decisions are made on the basis of extremely rudimentary and superficial expectations and estimates. Only in very particular situations and very limited in number is it possible to carry out formal studies of a logical or mathematical nature that make possible some modernization of the problem. At the same time, in many situations with which we are confronted on a daily basis, there is such a large quantity of elements influenced by such a high set of determinants, more or less significant, that one cannot even think of considering them all, unless less, attempting to explore the distinct meanings and effects. Therefore Knight identifies in the inadequacy of knowledge of the subjects, in the face of the extreme variety with which different categories of future events potentially arise, the fundamental determinant of uncertainty. The latter, in turn, is characterized by the variability with which the different events occur, by the unnecessariness and dynamism that characterizes the laws that link causes to effects. Knight observed that if all changes occurred according to unchanged and universally known laws, then it would be possible to predict future events long before their actual occurrence: universal knowledge would leave no room for any entrepreneur, whose role is to improve his own knowledge and your own prediction. Therefore, it is imperfect knowledge that constitutes the main constraint on understanding the change that causes uncertainty. Knight’s analysis leads to the statement that it must be conceived in a radical sense different from the common notion of risk, from which it has never been conveniently separated. According to Knight, the practical difference between the two categories, risk and uncertainty, is that in the former the individual probabilities are known, while in the case of uncertainty this is not the case. In particular, for Knight the risk indicates a quantity susceptible of evaluation, he defines it as a measurable uncertainty, even if, he adds, it is so different from a non-measurable one that in reality it is not at all uncertainty.  Consequently, it restricts the use of the term uncertainty to non-quantitative cases. Therefore, in general, the concept of risk is divided into two different dimensions which manifest themselves with profoundly different characteristics at the level of both the theoretical analysis of the consequent empirical characterization. Knight makes a distinction between measurable risk and non-measurable uncertainty; the risk and uncertainty therefore appear as a particular species or rather a component of a more general project and are characterized by the possibility of quantifying the probability of an occurrence of one or more events. In light of this definition, the author himself observes how the terms of objective and subjective probability can be used in order to identify risk and uncertainty. Objective and subjective probability differ due to the fact that, in the first case, the probability function that depicts the events in question is known or can be estimated through empirical analysis. In the second case, on the other hand, the probability is associated with the single events through a subjective evaluation process as the situation treated is characterized by the conditions of singularity and not of repetitiveness. Therefore, the risk refers to a situation in which you have some idea about the probabilities with which an event could occur; however, when the probability is completely unknown, there is uncertainty. Therefore, uncertainty is associated with a subjectivist concept of probability that indicates the degree of confidence that a subject assigns to the occurrence of an event; while the risk is characterized by the probability which is based on the frequency with which certain events occurred in the past: in other words, the risk is identified and quantified in the statistical probability.

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