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May 11, 2007

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Val Larsen

I think Nathaniel’s argument is valid. So let me reflect on why it is true that people are too risk averse and the policy implications of this excessive risk aversion. As Kahneman has demonstrated, people weigh prospective losses more heavily than equivalent prospective gains. This is unsurprising given the declining marginal utility of income. (In nature, less food means you starve to death while more food just means you get fat.) Moreover, entrepreneurs as a class are net losers--in part because they bear all losses but share gains with society (well paid employees, the government/general population through tax receipts). Given that the expected value of risk seeking is negative for the entrepreneur but positive for the larger society, it is rational to free ride on the risk seeking of others by being a skilled employee rather than an entrepreneur. Taken together, these factors produce less risk seeking entrepreneurialism than is socially/economically optimal. So public policy should encourage greater entrepreneurism.

I can think of several ways to do this. The most straightforward is minimize government takings of returns to entrepreneurism, e.g., by making income earned through an initial public offering tax free. In the same vein, the government might subsidize risk taking through a matching grant program that gave any entrepreneur who could come up with 80% of the cost of a venture the remaining 20% as a grant. (Experiment might determine the optimal proportion of the matching grant.) [ed. Wouldn't the cost of policing fraud be prohibitive?]

But the best solution may be a social insurance program because it addresses the nub of the problem—the heavily weighted fear of destitution rather than the more lightly weighted anticipation of a positive return which the subsidy and tax policies proposed above address. If entrepreneurs are guaranteed to fall only so far if they fail, more will be willing to take the leap of faith. This is, I think, the strongest purely economic argument one can make in favor of the welfare state. And its logic is strong. Taken as a whole (including the gains to employees and the state), the returns to entrepreneurism are strongly positive. So there is plenty of money to take from the overall winnings to subsidize the losers.

But there is an obvious hazard—populist socialism. It seems to be politically impossible to put a social insurance program in place that enrolls only entrepreneurs, though that might be economically optimal. When the program is generalized to the population as a whole, the money that must be taken from successful entrepreneurs can become so great that the reduction in positive incentives to invest (lower returns due to taxes) may be greater than the reduction in negative incentives not to invest (fear of destitution ameliorated by social insurance). What can probably be demonstrated is that there will be two equilibrium points where overall income gains are optimized, a lower one which bows to political necessity and includes everyone in the social insurance program, and a higher one which insures only entrepreneurs. When either optimal point is reached, there should be a dead weight loss to society if taxes are raised/lowered so that social insurance can be raised/lowered. In a word, there is a free lunch to be had--whatever the opposite of a dead weight loss is--from the correct policy.

Nathan Smith

Very interesting... but Val is arguing that "people are too risk-averse" in a somewhat different sense than I was. He's arguing that people are too risk-averse from the social point of view, that it would be socially optimal for people to take more risks. I was arguing that people might be too risk-averse even from the individual point of view, overestimating the utility loss from adverse change, underestimating the utility gain from beneficent change. Whether that's true I'm not sure.

Val's argument is much stronger than the one I was making, and now that I've heard it I think part of the reason for my intuition about excessive risk-aversion might come from risk-aversion being excessive from the point of view of social rather than individual welfare. In that case, we could reduce risk-aversion by inculcating greater altruism in people. In which case the efforts of those tireless altruism-mongers, the churches, might explain the apparent risk-aversion gap between the United States and Europe.

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The strongest purely economic argument one can make in favor of the welfare state. And its logic is strong. Taken as a whole (including the gains to employees and the state), the returns to entrepreneurism are strongly positive. So there is plenty of money to take from the overall winnings to subsidize the losers.

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