How the Market System Deals with Risk

Question 1

The profit system

Answer 1

1. ) It falls to those acting as the firm’s entrepreneurs to deal with risk
2. ) The entrepreneurs are guided by the so-called profit system. These individuals bear the risk; they win if there is a gain in profit and lose if there is a loss. Therefore, entrepreneurs must make prudent decisions to avoid unnecessary risks.
3. ) Command economies do not manage risk well because central planners do not face the risk themselves.

Question 2

Shielding employees and suppliers from business risk

Answer 2

1.) Under the market system, only a firm’s owners are subject to business risk and the possibility of losing money.

2. ) Because everyone is legally entitled to get paid before the firm’s owners, the firm’s owners are referred to as residual claimants in business law.
   - The firm’s employees and suppliers are not subject to risk. However, employees may bear employment risk, which depends on the profitability of the firm.

Question 3

Benefits of restricting business risks to owners

Answer 3

1. ) Attracting inputs
   - concentrating risk on owners allows firms to attract employees and suppliers
2. ) Focusing attention
   - profit maximizing behavior helps achieve prudent risk management

Question 4

Consider this insurance

Answer 4

1. ) Promotes economic growth and investment by transferring risk from those who have a low tolerance for risk to those who have a high tolerance for risk
2. ) Promotes growth and development by allowing individuals to pool the risk across a number of different individuals