Wednesday, December 15, 2010

Excessive whining about uncertainty

This article is one of many that complains about the inhibiting effect of uncertainty on business investment and other good things. Business people are supposed to be used to the idea of taking risks. The biggest risk they take is the decision to start a business at all, given the number that fail. For small risks, like variations in tax rates, it would seem that expected-utility theory is the way to go. You judge the probabilities, multiply them by the outcomes of various options, and pick the option with the highest weighted sum. They used to teach this in business schools. It is simple enough to teach in high school. A business that thought this way would, statistically, come out ahead of its competitors.

But a second problem is that people (i.e., those in business, overreact to salient risks and ignore the huge risks that are off screen. Compared to those huge risks, uncertainty about taxes is almost trivial. I'm reminded of a story about someone who presented a precise economic prediction of the price of oil over the next few years. One of the listeners asked, "Er. What about war in the middle east?"

A final comment. Some of this is not about risk so much as ambiguity, the psychological state of feeling that you are lacking crucial information. This is, as I have argued, something of an illusion, as we are always lacking crucial information whenever we cannot predict an outcome with certainty. We over-react when certain missing information, like what Congress will do with taxes, is called to our attention.

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