Thinking and Deciding

NORMATIVE THEORY 501
example, to rebuild a house that burned down or to replace a car that was destroyed
in an accident.
When the injurer compensates the victim, as when a child is induced to give back
something he has taken or when a victim sues an injurer in court, punishment and
compensation are linked. But sometimes these functions are separated. Criminals
are punished whether or not their victims are compensated. We can, then, and we
sometimes do, think separately about the functions of compensation and punishment.
The normative theory of monetary compensation is that money becomes more
valuable after a loss, so that total utility is increased by giving money to those who
lose. If your house burns down, you have a way of spending money to increase your
utility that you did not have before the fire. You gain more utility from spending
money on a new house than you could have gained from any way of spending money
before the fire.
Notice that this normative theory yields some strange results. It implies that
people in modern societies should probably not be compensated for the accidental
death of their children. When children die, parents lose ways of spending money to
increase utility. They can no long spend money on the children. Many other ways
of spending money to increase their utility are still available to them, but possibly no
more than when the child was alive.
Private insurance
Insurance also provides compensation for harm. Interestingly, very few people buy
life insurance policies on their children. This is consistent with the theory just described,
assuming that the death of a child does not increase the opportunity to spend
money to increase utility.
Insurance can also provide incentive to take care, just like liability. It does this
offering lower premiums to those who take precautions, such as installing air bags
or antilock brakes in cars (for automobile insurance), or not smoking (for health
insurance), or installing smoke detectors (for house insurance). If the reduction in
premiums equals the cost saving to the insurer, then people have an incentive to take
the optimal amount of care. The insurer must have some way to determine whether
the precautions are taken.
Investment and entrepreneurs
Most of the study of risk is about losses. Investing, despite its dangers, is mostly
about gains. In essence, the normative theory is expected-utility theory. The issue
is what to do with spare resources, such as money, or, in principle, time, that could
be put to some use. Investment has to do with buying shares of stock, buying bonds
(essentially lending money at a fixed rate of interest), buying property to rent or
sell later, starting small businesses, or joining with others to start a large business
or finance a corporate merger. We can also invest time in education, or in building
up a business. For each possible investment of time or money, we can gain or lose