Risk doesn’t just disappear
08/11/2012 § 2 Comments
The Pike River Mine report has brought the issue of risk and companies’ duties back up. The report found that the company exposed the workers to unacceptable risk. There is a very important discussion to have about ex ante and ex post perceptions of risk — Monday morning quarterbacking, to use an American phrase — but I won’t do that now. Instead, I want to focus on risk allocation and companies.
These things are called limited liability company (LLC) for a good reason. They limit the liability — the responsibility for failure. The company is a legal entity separate from its shareholders, and it bears its own risk. Shareholders can lose only their investments and no more.
This has proven a useful arrangement in the modern economy. If you try something out — a new product, a new store, a new technology — you can limit your losses. We have all benefited from this. The arrangement has encouraged risk-taking and innovation, and has helped create the material world in which we are living (cue Madonna?).
But, these things aren’t perfect.
Think of it this way. There is a distribution of uncertain outcomes. We can model this as the probabilities of good and bad outcomes. Let’s say that the following graph shows the probabilities of success. There’s a reasonable probability that things will go well and you’ll make money and so one. But, there is also a positive probability that you won’t succeed. Let’s say the black line marks the difference between business success and failure. The LLC allows you to truncate the distribution of outcomes that concern you; you get to lop off the left tail.
But, there is also a non-trivial probability that things will go horribly wrong. That’s what happened with the Pike Rive Mine. Think of these situations as the tail to the left of the red line. They won’t happen often, but they will happen. The probability doesn’t disappear. The LLC structure just moves the risk from the business onto other people.
We all benefit from this legal fiction, because of a more innovative and productive economy. On the other hand, some benefit more than others. That suggests a two-prong approach to dealing with this imperfection in LLCs:
- when a few people bear the burden of the rare disasters, they should get help from the rest of us. After all, they have ended up in the left tail while the rest of us enjoy the bulk of the probability distribution
- those who benefit more — those who chop off more of the left tail than the rest of us — should pay for the privilege.
There’s not much concrete policy in those ideas, but I’m sure we can work it out later.