Risky business

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risky-business_lThe other day, my brother told me how relieved he was at having been able to purchase a ticket to the United States for an upcoming business meeting. The price tag? BsF 21,000, which at the SICAD rate airlines will supposedly be getting comes out to roughly US$1,750, an outrageous figure. In fact, airplane tickets to Venezuela have been sky-high for years now.

This is not uncommon in Venezuela. More often than not, Venezuela is listed as one of the most expensive places on Earth. Now, there are a million reasons why this is so, but a big part of it lies with a concept that I try to explain to my students every semester: the price of risk.

Human beings don’t like risk. We dislike it so much, we are willing to pay money to avoid it, or we charge extra if we have to face it.

Let me give you an example: suppose I were to tell you about a game in which I flip a coin. If the coin lands on “heads,” you win $50. If the coin lands on “tails,” you win $100. To play this game, you need to buy a ticket. How much would you be willing to pay for it?

Surely you will pay at least $50 for it, since it’s the minimum you would be able to earn. But you will also, most likely, pay less than $75, which is the “expected value” of the payoff (equal to $50 times 0.5 plus $100 times 0.5). In other words, $75 is the average payoff, but you would be willing to pay a little less than that.

Why? Because there is risk involved.

If you were to pay $75, you will end up either winning $25 (tails) or losing $25 (heads). In other words, you end up in the same place you were before playing the game. Surely you prefer to pay a little less with the hope of making an (expected) profit, right? Otherwise, why play? Therefore, the maximum willingness to pay for the ticket lies somewhere between $50 and $75.

If that is true, the I, the “seller” of this game, find myself selling something that is “worth” $75 for slightly less than $75. That money I am giving up, that income I don’t make, is due to risk. Risk is costly – costly for the sellers, and costly for the buyers.

Let’s translate this idea to the markets in Venezuela. When the airline is selling you a ticket, it might have a promise to translate its earnings at the SICAD rate, but there is no guarantee. The SICAD rate could be devalued, or the government could simply refuse to give them access to dollars. Even the spare parts on its plane could be stolen. A million things could go wrong.

In order for the airline to be willing to sell in this highly risky market, it needs to be able to “cover” the cost of risk, just like you need to cover the cost of everything else – labor, transportation, etc. Otherwise, it makes no sense for you to sell in this market. Just ask Toyota!

In other words, there is considerable risk involved, and risk is expensive. Therefore, the airlines have to charge you extra to account for this risk. This is true for airplane tickets, for people lending money to Venezuela, and for pretty much everything else in the country. Whether it’s the risk of your goods being stolen, not having access to dollars, or even the risk of expropriation, the bottom line is that doing business in Venezuela is mighty risky, and consumers have to pay for that.

The government of Nicolás Maduro now has a law regulating every firm’s earnings at a maximum of 30%. In order to evaluate compliance with the law, it is supposedly going to evaluate the cost structure of each company, deciding which costs can be taken into account in order to set prices, and which cannot.

Whatever they decide, you can be sure that the cost of risk will not be an allowable item when estimating the maximum prices, which means companies will not be able to cover a huge amount of the cost they bear when doing business in Venezuela. In other words, they will be tempted to simply leave, which is why this law will only increase the empty shelves in Venezuela’s markets.

Brace yourselves.