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Frank Hyneman Knight

(November 7, 1885 – April 15, 1972)

Risk, Uncertainty and Profit (1921)

Frank Hyneman Knight (November 7, 1885 – April 15, 1972) was an important economist of the twentieth century. He was born in McLean County, Illinois in a devoutly Christian family of farmers. He never completed high school but was admitted in 1905 to the American University in Tennessee. He graduated in 1911 from Milligan College. At the University of Tennessee he obtained a B.S. and an M.A. (the latter in German) in 1913. He then moved to Cornell University for doctoral studies. His initial main subject was philosophy, but he soon switched to economics. He studied with Alvin Johnson and Allyn Young, who both supervised the work on his dissertation, that was completed in 1916 under the title Cost, Value and Profit. Knight would subsequently revise it for publication under its more familiar name Risk, Uncertainty and Profit (1921).

Jointly with Jacob Viner, Knight presided over the Department of Economics at the University of Chicago from the 1920s to the late 1940s, and played a central role in setting the character of that department that was perhaps only comparable to Schumpeter’s tenure over Harvard; Robbins’s at the L.S.E or Paul Samuelson’s at MIT.

His famous dissertation Risk, Uncertainty and Profit (1921) remains one of the most interesting reads in economics even today. In it, Knight made his famous distinction between “risk” (randomness with knowable probabilities) and “uncertainty” (randomness with unknowable probabilities), set forth the role of the entrepreneur in a distinctive theory of profit and gave one of the earliest presentations of the now-famous law of variable proportions in the theory of production.

Knight invented the notion of what has come to be called Knightian uncertainty, where he made a distinction between risk and uncertainty. He argued that situations with risk were those where decision making was made faced with unknown outcomes but known ex-ante probability distributions. He argued that these situations, where decision making rules such as maximizing expected utility can be applied, differ in a deep way from those where the probability distribution of a random outcome is unknown. While most economists today would recognize the difference between the two situations, there has been little progress in terms of writing models and doing empirical tests of problems with Knightian uncertainty. A possible exception is the “Markets from Networks” model developed by sociologist Harrison White in 2002.

He entered a famous debate with A.C. Pigou over social costs. He also made contributions to the arguments about toll roads. He said that rather than congestion justifying government tolling of roads, privately owned roads would set tolls to reduce congestion to its efficient level. In particular, he developed the argument that forms the basis of analysis of traffic equilibrium, and has since become known as Wardrop’s Principle:

Suppose that between two points there are two highways, one of which is broad enough to accommodate without crowding all the traffic which may care to use it, but is poorly graded and surfaced; while the other is a much better road, but narrow and quite limited in capacity. If a large number of trucks operate between the two termini and are free to choose either of the two routes, they will tend to distribute themselves between the roads in such proportions that the cost per unit of transportation, or effective returns per unit of investment, will be the same for every truck on both routes. As more trucks use the narrower and better road, congestion develops, until at a certain point it becomes equally profitable to use the broader but poorer highway.

Risk, Uncertainty, and Profit

First Pub. Date 1921

Knight, Frank H. (1885-1972)

TABLE OF CONTENTS

Risk, Uncertainty and Profit, 1921

Preface

Author’s Preface

Part I Introductory

I.I The Place of Profit and Uncertainty in Economic Theory

I.II Theories of Profit; Change and Risk in Relation to Profit

Part II Perfect Competition

II.III Theory of Choice and of Exchange

II.IV Joint Production and Capitalization

II.V Change and Progress with Uncertainty Absent

II.VI Minor Prerequisites for Perfect Competition

Part III Imperfect Competition through Risk and Uncertainty

III.VII The Meaning of Risk and Uncertainty

III.VIII Structures and Methods for Meeting Uncertainty

III.IX Enterprise and Profit

III.X Enterprise and Profit (continued)
The Salaried Manager

III.XI Uncertainty and Social Progress

III.XII Social Aspects of Uncertainty and Profit

Footnotes

Risk, Uncertainty and Profit, 1921.

Major publications:

• “The Concept of Normal Price in Value and Distribution”, 1917, QJE.

• Risk, Uncertainty and Profit, 1921.

• “Cost of Production and Price Over Long and Short Periods”, 1921, JPE.

• “Cassel’s Theoretische Sozialökonomie”, 1921, JPE.

• “Ethics and the Economic Interpretation”, 1922, QJE (repr. in 1999, I)

• “The Ethics of Competition”, 1923, QJE (repr. in 1999, I)

• “Some Fallacies in the Interpretation of Social Cost”, 1924, QJE (repr. in 1999, I)

• “The Limitations of Scientific Method in Economics”, 1924, in Tugwell, editor, Trend of Economics (repr. in 1999, I)

• “Fact and Metaphysics in Economic Psychology”, 1925, AER (repr. in 1999, I)

• “A Note on Professor Clark’s Illustration of Marginal Productivity”, 1925, JPE.

• “Economic Psychology and the Value Problem”, 1925, QJE.

• “Economics at its Best: Review of Pigou”, 1926, AER.

• “Historical and Theoretical Issues in the Problem of Modern Capitalism”, 1928, Journal of Econ & Business History (repr. in 1956 & 1999, I)

• “A Suggestion for Simplifying the Statement of the General Theory of Price”, 1928, JPE.

• “Freedom as Fact and Criterion”, 1929, Int J of Ethics

• “Statics and Dynamics: Some queries regarding the mechanical analogy in economics”, 1930, ZfN (repr. in 1956 & 1999, I)

• “Professor Fisher’s Interest Theory: A case in point”, 1931, JPE.

• “Modern Economic Society Further Considered”, 1932, JPE.

• “The Newer Economics and the Control of Economic Activity”, 1932, JPE (repr. in 1999, I)

• The Economic Organisation, 1933.

• “Capitalistic Production, Time and the Rate of Return”, 1933, in Essays in Honor of Gustav Cassel (repr. in 1999, I)

• “The Nature of Economic Science in Some Recent Discussion”, 1934, AER.

• “Social Science and the Political Trend”, 1934, Univ of Toronto Quarterly

• “Common-Sense of Political Economy: Wicksteed Reprinted”, 1934, JPE (repr. in 1956)

• The Ethics of Competition and Other Essays, 1935.

• “The Ricardian Theory of Production and Distribution”, 1935, Canadian JE (repr. in 1956 & 1999, I)

• “A Comment on Machlup”, 1935, JPE.

• “Professor Hayek and the Theory of Investment”, 1935, EJ.

• “The Theory of Investment Once More: Mr. Boulding and the Austrians”, 1935, QJE.

• “Some Issues in the Economics of Stationary States”, 1936, AER.

• “The Place of Marginal Economics in a Collectivist System”, 1936, AER.

• “The Quantity of Capital and the Rate of Interest”, 1936, JPE (repr. in 1999, I)

• “Pragmatism and Social Action: Review of Dewey”, 1936, Int J of Ethics

• “Note on Dr. Lange’s Interest Theory”, 1937, RES.

• “Unemployment: and Mr. Keynes’s revolution in economic theory”, 1937, Canadian JE (repr. in 1999, I)

• “On the Theory of Capital: In reply to Mr. Kaldor”, 1938, Econometrica.

• “The Ethics of Liberalism”, 1939, Economica.

• “Socialism: The nature of the problem”, 1940, Ethics (repr. in 1999, II)

• “‘What is Truth’ in Economics”, 1940, JPE (repr. in 1956 & 1999, I)

• “The Significance and Basic Postulates of Economics: a rejoinder”, 1941, JPE

• “Religion and Ethics in Modern Civilization”, 1941, J of Liberal Religion

• “The Meaning of Democracy: its politico-economic structure and ideals”, 1941, J of Negro Education

• “Social Science”, 1941, Ethics (repr. in 1956)

• “The Business Cycle, Interest and Money: A methodological approach”, 1941, REStat (repr. in 1956 & 1999, II)

• “Professor Mises and the Theory of Capital”, 1941, Economica.

• “The Role of the Individual in the Economic World of the Future”, 1941, JPE.

• “Science, Philosophy and Social Procedure”, 1942, Ethics

• “Fact and Value in Social Science”, 1942, in Anshen, editor, Science and Man

• “Some Notes on the Economic Interpretation of History”, 1942, Studies in the History of Culture (repr. in 1999, II)

• “Social Causation”, 1943, American Journal of Sociology (repr. in 1956)

• “Diminishing Returns Under Investment”, 1944, JPE.

• “Realism and Relevance in the Theory of Demand”, 1944, JPE (repr. in 1999, II)

• “The Rights of Man and Natural Law”, 1944, Ethics (repr. in 1999, II)

• “Human Nature and World Democracy”, 1944, American J of Sociology.

• “Economics, Political Science and Education”, 1944, AER

• The Economic Order and Religion, with T.W. Merriam, 1945.

• “Immutable Law in Economics: Its reality and limitations”, 1946, AER.

• “The Sickness of Liberal Society”, 1946, Ethics (repr. in 1999, II)

• “Salvation by Science: The gospel according to Professor Lundberg”, 1947, JPE (repr. in 1956)

• Freedom and Reform: Essays in economics and social philosophy, 1947.

• “Free Society: Its basic nature and problem”, 1948, Philosophical Review (repr. in 1956)

• “The Role of Principles in Economics and Politics”, 1951, AER (repr. in 1956 & 1999, II)

• “Institutionalism and Empiricism in Economics”, 1952, AER.

• On the History and Methods of Economics: Selected essays, 1956.

• Intelligence and Democratic Action, 1960.

• “Methodology in Economics”, 1961, Southern EJ

• “Abstract Economics as Absolute Ethics”, 1966, Ethics.

• “Laissez Faire: Pro and con”, 1967, JPE (repr. in 1999, II)

• “The Case for Communism: From the Standpoint of an Ex-liberal.” (published posthumously) in Research in the History of Economic Thought and Methodology, edited by Warren J. Samuels, archival supplement 2 (1991): 57-108.

• Selected Essays by Frank H. Knight, 2 vols., (ed. by Ross Emmett), 1999.

More than eighty years ago, Frank Knight set out to parse the difference between risk and uncertainty and the significance of that difference. In Risk, Uncertainty and Profit, Knight distinguished between three different types of probability, which he termed: “a priori probability”; “statistical probability” and “estimates”. The first type “is on the same logical plane as the propositions of mathematics”; the canonical example is the odds of rolling any number on a die. “Statistical probability” depends upon the “empirical evaluation of the frequency of association between predicates” and on “the empirical classification of instances”. When “there is no valid basis of any kind for classifying instances”, only “estimates” can be made. In contemporary Bayesian parlance, in the first case, the probability distribution of the prior and all its moments are known definitionally; in the second case they are specified by statistical analysis of well-defined empirical data; in the third case such data as exists do not lend themselves to statistical analysis.

This last case is what interested Knight the most, as an economist exploring the world of business and the nature of profit in that world. Knight identified the “confusion” between “the problem of intuitive estimation” with “the logic of probability”, whether a priori or statistical:

The liability of opinion or estimate to error must be radically distinguished from probability or chance of either type, for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability. Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable…

“At the bottom of the uncertainty problem in economics”, Knight noted, “is the forward-looking character of the economic process itself.” The post-Keynesian economist Paul Davidson defined the problem as the inapplicability of the “ergodic axiom”:

The economic system is moving through calendar time from an irrevocable past to an uncertain and statistically unpredictable future. Past and present market data do not necessarily provide correct signals regarding future outcomes. This means, in the language of statisticians, that economic data are not necessarily generated by an ergodic stochastic process. Hicks has stated this condition [in language that prefigures Rumsfeld] as: “People know that they just don’t know”.

When Knight turned to the role of profit as the reward to the entrepreneur for bearing inevitable uncertainty, he characterized these facts of economic life in the most stark of terms:

Profit arises out of the inherent, absolute unpredictability of things, out of the sheer, brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless.

Analysts have documented what Frank Knight meant by “uncertainty” to clarify what is at stake in applying the calculus of financial “risk” to issues of economic and, indeed, social security.

More than fifty years ago, “mainstream” economics launched itself on the grand project to formalize the principles of economics in rigorous mathematics. Unsurprisingly, such a system was as incapable of incorporating Knight’s “uncertainty” as it was of addressing the “extreme precariousness” of expectations and confidence described so eloquently in Chapter 12 of Keynes’ General Theory.

For a time, the “rational expectations hypothesis” (REH) served as a sort of placeholder for serious consideration of the fundamental issues that Knight addressed and the consequences of which Keynes explored. It is not, I believe, an excessive caricature of REH to say that it turns on the assumptions that (1) all market participants have equal access to the same data; (2) all market participants share one model of how the world works, application of which translates data into meaningful and actionable information; and (3) that model happens to be “the truth” (and is identified recursively with “mainstream” general equilibrium theory). In this world, bubbles and panics cannot exist. All risks can be priced and insured or effectively hedged through the construction of appropriate contingent, derivative securities markets which are assumed to exist.

Frank Hyneman Knight

(November 7, 1885 – April 15, 1972)

Risk, Uncertainty and Profit (1921)