States with high probabilities and medium returns in the population

Yesterday I suggested that when there is a state with a very tiny probability occurs, many people are betting against the existence of the state; therefore, when the state becomes the reality, it causes greater impacts than the difference of the expected outcome and the state outcome. Today I want to further discuss this topic.

The expected outcome is the accumulation of the products of each state's probability and its outcome. However, when it comes to individual decisions, in some cases, individuals have to make their choices between several states and the expected outcomes are not guaranteed. Each individual has his/her personal risk preference and based on their risk preferences, they choose their preferred states. It is commonly believed that the majority of the population has risk averse risk preferences. If I assume that all individuals in the population have risk averse risk preferences, when a state has a higher probability, the number of people choosing this state becomes larger. When more people choose one particular state, the price for this state rises as the demand increases, so the return for the state decreases. Vice verse, the returns for states with lower probabilities become larger.

In addition, if assuming it is a zero-sum game, the overall outcome does not change, so the average return does not change and is meaningless. The median outcome or return in the population changes when we assume risk averse risk preferences or risk neutral risk preference, as the number of people choosing states with high probabilities under the risk averse risk preference assumption is greater than the number under the risk neutral risk preference assumption, the returns for states with high probabilities under the risk averse risk preference assumption are lower than the returns for the same states under the risk neutral risk preference assumption. Therefore, the median return of individuals when the general risk preference of the population is risk averse is lower than the median return and the expected return of individuals when the general risk preference of the population is risk neutral.

Election, politics and economics

Nowadays, I start to think the most significant, influential political events are black swan events. The majority of the political events including elections, referendums is not black swan events and has clear probabilities and has limited influence on the markets as well as the economies. Usually, when the unlikely states of such events take place, they may cause immediate shocks in the markets and the economies in the short term; however, in a relatively long term, such impacts are relatively less significant. This is because of several reasons. Firstly, when there are several parties in politics, the best strategy for any of them to win the political power is to target the middle voters, this will make their political actions more and more similar and the expected policy changes due to politics become less significant. Secondly, politics has been partially serving the economics. Many governments have found that to gain political power and influence and provide political stability, they have to build strong economies to make their people become wealthier. When they design political decisions based on economic factors, the people in the markets and the economies are gaining more information and even directing the political actions, so they have the better estimation of future political changes and their impacts on the markets and the economies. Thirdly, globalisation and other communications and cooperation across sectors have made one individual change be much more difficult to cause significant impacts on the whole.

However, there are some rare events which seem impossible taking place. These events are out of control and hard to be predicted; moreover, the majority of the population ignores their existences before they take place or believe they will never occur. Under such circumstance, these events occur and cause significant impacts on our economies and markets.These events do have the same characteristics that black swan events have, as the majority of the population ignore their existence and are betting against them. The reason that makes them have such characteristics is not about their causes or probabilities, it is because their probabilities are too small and the majority of the population choose to bet against their existence and such irrationality is the black swan factor in these cases.

Black swan and its computability

One of three important characteristics of black swan events is its non-computability and one of the most important factors that cause the economic crises is these black swan events. As I mentioned yesterday, the most common way to deal with black swan events is to ignore these black swan events, because usually, these events are unknown. If we do not know the existence of these black swan events or their causes, we do not have any effective way to estimate their likelihood and their expected costs. Yesterday I said that terrorist attacks could be seen as black swan events; however, the governments cannot treat terrorist attacks as black swan events and they use all available resources to find information about the possibilities of terrorist attacks and estimate the possibilities. The actions taken by the governments make terrorist attacks no longer black swan events, as when the more information is held, the easier it becomes to estimate the possibility.

It is the same for other known black swan events; of course, we still do not have any method to deal with unknown black swan events. For known black swan events, the main reason for the existence of known black swan events is their causes are complicated or unknown. When having more information, it helps to understand some of their causes and improve the accuracy of estimating the possibilities. However, collecting information has costs, especially when collecting difficult and complicated information. In addition, the costs also increase when using the collected information to conduct complicated models to estimate the possibilities. It is impossible to estimate the possibilities perfectly. When dealing more complicated factors, the costs increase significantly, as they have to recruit experts and buy high-speed computers to design and conduct complicated models. When the costs of collecting information and estimation are too high, some events automatically become black swan events.

Terrorist attack's economic costs

Terrorist attacks are horrifying and kill so many innocent lives; however, the costs of terrorist attacks are far more than killing and hurting innocent people. They have significantly high social costs including economic costs.

Firstly, the existence of terrorist attacks makes all the governments under terrorist threats have to have spent significant government funding to fight against terrorist attacks. Such use of resources is definitely going to occupy the uses of resources in other sectors: people are recruited from other sectors, including data analysis, money and equipment are taken from other fields as well. The returns of such use of resources mainly focus on the anti-terrorist field and such use of public resources has relatively limited multiple effects than government investment in other fields does. Secondly, terrorist attacks are almost black swan events that are non-computable (and other characteristics that black swan events have) and add more uncertainties to our individual lives and activities as well as business operations and other economic activities. Although when dealing with black swan events, we usually choose to ignore the effects of black swan events, once a terrorist attack occurs, it will cause an immediate damage to our society and terrorist attacks in the short term no longer are black swan events and based on the information released from intelligent agencies and other government parts, people are able to compute the risks of terrorist attacks and this immediately increases the short-term costs, as the possibility of terrorist attacks lowers the expected returns. Thirdly, terrorist attacks could increase the possibilities of social unrest and discrimination, the recent example is the US president's proposed migration ban. This also increases of our social costs.

Overall, the damage of terrorist attacks increases the costs of providing security and raises the social uncertainties.

How much can the financial market prices influence the inflation rate?

Yesterday I talked about the price changes in financial markets and ordinary markets follow some different rules, today I want to discuss the interaction between the prices in financial markets and the prices in ordinary markets.

My understanding is that the prices in financial markets represent the demand for the supply side. When investors believe there is more production in the future, the prices in financial markets are likely to increase. Such increase in the demand for more investment on the supply side could be caused by several reasons. Firstly, it could be caused by an increase in the demand side, as when more demand appears in the market, the market price increases and it can attract more investment in the field. Secondly, it could be caused by an increase in the expected returns in the future. If it is caused by the first reason, the prices in financial markets and ordinary markets move in the same direction with similar degrees. Under such circumstance, we can say that the price changes in ordinary markets lead to price changes in financial markets, as the increase in demand in ordinary markets is the cause. If it is caused by the second reason, the prices may move in the same direction; however, the prices in financial markets are likely to increase with greater degrees than the prices in ordinary markets. Under this situation, usually, price changes in financial markets do not affect the prices in ordinary markets, as the prices in financial markets are influenced by the expected returns in the future but the expected returns in the future do not affect the utilities gained from consumption in ordinary markets so have no influence on prices in ordinary markets.

Overall, the ordinary market price changes could have impacts on the financial market prices but the price changes in financial markets have limited influence on the ordinary market price level.

The pricing setting differences in the ordinary market and the financial market

Prices are set in the financial market and the ordinary market based on some similar concepts and some different concepts. Let's discuss the similar concepts first. Prices are set in the both markets based on the relationship of demand and supply. It is almost the Golden rule that when the supply increases, the price will decrease and when the demand increases, the price will increase. Both markets follow this rule without a doubt. Secondly, in both markets, the concepts of substitutes and compliance goods remain and prices change accordingly. Thirdly, in reality, both markets are not perfectly competitive and there is no perfect information in either market. Of course, the two markets have many different characteristics.

Firstly, the prices of goods in ordinary markets are believed to be diminishing over time; however, many assets in the financial markets usually have increasing prices, especially when they are believed to good assets. This is because the utility of an ordinary good is fully consumed once the good is assumed, and the value of the good is diminishing over time. In addition, in a perfectly competitive, prices should be equal to the costs of production which are certain. However, a financial asset is different. The utility and benefit of a financial asset are not fully consumed when they are consumed. Moreover, the price is set based on people's expected returns and expected costs. When the time is processing, some uncertainties become certain, so the expectations are changing over time, thus prices are more likely to increase over time when some risk disappear over time. Moreover, financial assets can produce returns over time and ordinary goods cannot produce any further values. Secondly, in ordinary markets, the supply side is usually the side with more market power; in financial markets, the demand side usually can have more power than the supply side. Of course in both markets, there are some exceptions. This is because, in financial markets, the demand side has the rare resources, cash, that all the supply parties are bargaining for; in other words, the demand side controls the rarity in the market. Thirdly, when goods are traded freely without limitation, in ordinary markets, large demanders can have price advantages; while in financial markets, smaller demanded can have more price advantages. This is because when bargaining for the same financial asset, the supply is usually constrained, and prices are set at different prices, small consumers can consume at the market price but large demanders demand more than the market can supply at the current level, so when they want to consume the full amount, they have to lift the market price and lose price advantages.

The oil price and the economic growth

Yesterday I pointed out during an economic boom the oil price would be highly likely to be relatively higher than when it is an ordinary time period. However, how much can we use the oil price as an indicator of the outputs of our economy?

It is reasonable because crude oil is many products' important raw materials and fuel most motor engines, crude oil could partially represent the general production of the world economy, when the amount of the global outputs is large, the demand for crude oil is definitely high, and vice versa. From this side, the increase in the world demand will lead to an increase in the demand for crude oil, thus increasing the oil price. However, oppositely the supply side of crude oil could also impact on the oil price.

As the market for crude oil is an oligopoly market, the OPEC has significant power to impact the oil price; therefore, the oil price is partially controlled by the supply side. When the supply side has some control over the market oil, the oil price does not fully reflect the actual changes of market supply and demand. Therefore, when the OPEC does not have any actions in the oil market, the oil price could reflect the market demand for crude oil, and the global outputs.

However, sometimes the OPEC's action is not obvious and is hard to be seen. When this is the case, we can use the economic growth in these OPEC countries, when there is a significant change in the economic growth rates in these countries comparing with the global economic growth rate, we could say that the possibilitiy of taking actions in the oil market to impact the price change is high, so the credibility of using the oil price to reflect the world economic growth.