I was trained to shape policy, advise captains of industry, or write research papers at a university. And yet there I was, sitting on a red velvet sofa in a vinyl-sided house in a remote corner of Nevada because unusual markets like sex work thrive on risk. We can always find better ways to measure and reduce risk, so I go wherever people might be defying the odds. After all, financing retirement when you don’t know if the stock market will soar or crash, or how long you will live, requires mastering risk.
Sex work is a risky business. I went to Nevada to understand how the industry isolates and assigns a price to this risk. Most sex workers and their clients could be arrested or subject to violence. Sex workers who find their customers on the streets are thirteen times more likely to be murdered than the general population. Thirty-five percent of sex- worker homicides are committed by serial killers. Paying for or selling sex carries a stigma: sex workers and their customers face social, pro- fessional, and legal repercussions if they are caught. I went to the brothel to understand what it costs to eliminate this risk.
A 50 percent cut is what sex workers pay to eliminate their risk. Sex customers pay a 300 percent markup. Is this too much or too little? You decide.
The market for sex is an extreme example, one in which most of us will never participate. That markup reflects the price the market has assigned to risky sex. Unusual markets often provide the clearest insight into how risk is assessed, bought, and sold. Because nothing is hidden in markets like sex work, the subtleties that exist in all markets are made obvious. This is why we can learn the most by studying how business is conducted at the edges of the economy and ap- ply that knowledge to more typical economic transactions.
Think about how often we are given the option to pay to reduce risk: we are offered an extended warranty on a new appliance, we are offered different fare classes on a flight that increase the odds of getting space in the overhead compartment, or we are offered the variable or fixed interest rate on a loan. In each situation, we either give up something to reduce risk or take a gamble so we can get more for less. In the brothel, the price of risk is front and center: both sex workers and customers know exactly what they are paying for. In more everyday transactions, the price of risk may be hidden in the fine print or bundled with other services.
Financial science aims to separate out what portion of a price is driven by risk. Once that price is clear, it becomes much easier to identify the risks we face and figure out the best ways to take and reduce risk. Each chapter of this book will help you gain deeper in- sight into how risk can be valued, enhanced, or reduced by exploring different markets through the lens of financial economics. This offers a framework to understand the role risk plays in unusual, disparate markets.
In most areas of economics, value is based on scarcity. It doesn’t work quite the same way in financial economics. Financial economics assumes risk is also a critical component of value. Goods that lessen risk tend to cost more. This critical piece of information can revolutionise the way you assess everyday decisions and help you make better, more informed choices.
Let’s examine how this principle plays out in the pricing of airline fares. You may not realise it, but when you buy the cheapest ticket, you are at the top of the list to be bumped if the airline oversells the flight – check out the fine print. A cheap ticket comes with the risk of being forced to miss your flight. Purchasing a more expensive ticket reduces that risk.
Making a good risky decision requires transparency and spotting what you are paying for risk. In a poorly functioning market, we cannot make this distinction. For example, prices are not transparent in underground markets like criminal enterprises (think of illegal sex work before the Internet), so risk cannot be rationed based on price.
Price opacity is why sex work traditionally had a flawed risk allocation; pimps took most of the money and almost none of the risk. Crime is an extreme example, but when prices are not clear it’s more common for us to overpay or take on more risk than we realise – remember, the cheaper the airline ticket, the higher the odds of getting bumped for that discount.
Some markets do not reward risk in a sensible way, usually because something interferes with its proper functioning; for example, information is scarce, risk is hard to measure, or something limits competition among buyers or sellers of risk. In later chapters I will explain how an impaired risk market is behind all those bad movies made in Hollywood and slower racehorses.
When we’re able to isolate risk in a transaction and determine how it is valued, we can make better decisions. Finance uses many technical tools to identify, price, and sell risk, but the basic ideas behind them are easy to understand and apply to any market or problem. Once you master these tools, you’ll never again hesitate when choosing a restaurant, a health insurance plan, or an extended warranty.
Adapted from An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk by Allison Schrager with permission of Portfolio, an imprint of Penguin Publishing Group, a division of Penguin Random House LLC. Copyright © Allison Schrager, 2019.