The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 27

Prices, Probabilities, and Predictions

The second half of the twentieth century was devoted to debating the relative merits of planned economies versus free markets. In case you missed it, the winner was announced with the collapse of the former Soviet Union and the rise of China. As Adam Smith pointed out in his 1776 Wealth of Nations, the best way to generate wealth is through free markets, in which prices guide the allocation of goods and services.¹

A recent endorsement of this principle came from a surprising source: Russian Prime Minister Vladimir Putin in his January 28, 2009 address to the World Economic Forum in Davos Switzerland.² He warned that in a financial crisis: “Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent.” But, he continues, “In the 20th century, the Soviet Union made the state’s role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated.”

Prices are, in effect, the neurotransmitters of society, reflecting wants, needs, fears, estimates of future supply, outcomes of horse races, and so on. Prices are also intertwined with the concept of probabilities, which in turn drive predictions. My father was an early advocate of subjective probability. He encouraged me from a young age to think of the probability of an event as the amount of money I would gamble to win a dollar if ...