Risks and Rewards, Capitalism and Communism

P for Paul

The relationship between risk and rewards is a much studied phenomenon. The relationship is fundamental to behavioral economics and states that the higher the perceived risk the greater the expected reward.

The relationship frequently is assigned the name of “tradeoff,” as in “the tradeoff between risk and reward.” This label is somewhat of a misnomer, however, for tradeoff implies that the greater is one quantity, then the lesser is the other. Risk and reward go together; both go up or both go down

In an effort for greater understanding the econometrician quantifies risk and reward. Risk frequently, but not always, appears as variability of return on investment, the statistical variance. Reward frequently, but not always, appears as mean return. Alternative quantities, respectively, can be semi-interquartile deviation and median.

In a capitalist society risk in the form of entrepreneurship is encouraged. In consequence variability is high. Some succeed greatly. Others fail. Also, though, expected reward is high, providing the incentive to entrepreneurs. In a communist society risk is discouraged. Equality of outcome is stressed, leading to reduced variability of performance. In consequence mean results are low. In both forms, capitalism and communism, human nature is the same. Risk and reward go together.

It is no surprise, therefore, that capitalist societies are more productive and communist societies are less productive. It all has to do with human reaction to circumstances. Risk and reward go together.

The econometrician goes further to define and analyze this relationship. He speaks of the “efficient frontier.” This is where one maximizes return, given variance, or minimizes variance, given return. In the investment world this means adjusting one’s portfolio to achieve these goals. The efficient frontier emerges as a curve on a graph. At any point this curve has a slope, which defines, at that point, the quantified relationship between risk and reward.

The difference between capitalism and communism now becomes clear. In a free capitalist society the entire efficient frontier is available for choice by the citizens. In a communist society availability of the curve by the subjects is artificially restricted by state control to the low variance/low mean end. For the communist society, the stated purpose is to pursue a goal of “social justice.” The uniform result is an empoverished society.

One may make comparisons to the calls for intensive surveillance to maintain state security, down to the demands of university students for “safe spaces.” Inferences await as well the student of Scandinavian cradle-to-grave welfare states. These pursuits are left to the reader.

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