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Risk, Uncertainty and Profit

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This is the best work of economic theory I have ever read. There is no work in economics that evinces better judgment on the main issues or that does a better job of balancing theory with a sense for the facts. Knight begins by defending theoretical (that is, deductive) economics. Unlike the economic rationalists, however, Knight does not believe that theoretical economics can lead to precise results. The application of the "analytic method" must always be "incomplete," he argues. Theoretical economics thus can only deal with "tendencies," that is, "with what 'would' happen under simplified conditions never realized, but always more or less closely approached in practice." This methodology Knight describes as "the method of successive approximations." Knight also warns of the dangers of rationalism and the necessity of constantly checking one's results against the facts. "When the number of factors taken into account in deduction becomes large, the process rapidly becomes unmanageable and errors creep in... It is better to stop dealing with elements separately before they get too numerous and deal with the final stages of the approximation by applying corrections empirically determined."

Armed with the method, Knight proceeds to tackle several important problems in economics, especially dealing with the theoretical construct of "perfect competition." By always keeping his head firmly within the empirically real, Knight is able to bring a great deal of sound judgment to a number of issues. Knight had a keen sense of human nature and how human beings behave in the real world of fact. He knew that most economists had made men out to be far more rational than they really were. Businesses, he argued, did not merely seek to meet the needs of the consumers; no, they sought to create new needs through innovation, advertising, and even a sort of manipulative hypnotism. In this, Knight argued, we find both progress and abuse, civilization and fraud. Knight also brings a good deal of sense to the problem of interest, demonstrating the psychological inadequacy of all time-preference theories of interest. But Knight's most important contribution consists in his analysis of the difference between risk and uncertainty. Risk, Knight argues, is a measurable probability that something could happen, like the probability that an individual will be struck by lightening or hit by a car. Uncertainty is a kind of immeasurable risk--e.g., predicting short term flucations in exchange rates. Knight's analysis is crucial to understanding economic reality. Knight's distinction between risk and uncertainty, for instance, explains why the rise of derivative securities in financial markets is so dangerous. Derivatives attempt to insure uncertainty, which is immeasurable, as if it were risk (which is measurable).

Knight's work is a classic. Unfortunately, the Kessinger "reprint" listed here is actually a terrible photocopy of someone's desk copy of the old Houghton Mifflin printing. The print is dark and unclear and there are underlinings and marks on the text throughout this book from someone--I am not kidding when I say it is actually a photocopy. I am not sure how this is even legal, or why this product is sold on Amazon. Shame on them. I am returning my copy and going with another version. I suggest you do too.

Knight's Risk,Uncertainty and Profit(RUP) is a classic work ,especially with respect to Knight's analysis of the distinction between risk and uncertainty and the role each plays in the decision making calculus of the entreprenuer or the firm.For instance,Knight recognized that the negative impact of uncertainty could be reduced for those firms that were able to increase their size and get larger and larger over time.Advertising would allow firms to deal with the uncertainty of consumer responses to the introduction of new products over time ,as well as to changes in consumer preferences.Knight was the first to clearly recognize that economic profit is the return to the successful entreprenuer or owner of the firm to compensate them for the bearing of uncertainty.Knight's analysis of the connection between uncertainty and economic profit corrected the errors of Ricardo and Marx,who regarded economic profit as an unearned surplus .Keynes's integration of expected economic profit into the specification of his aggregate supply function,Z,where Z =P+wN(P equals expected economic profit),can be traced back to Knight's earlier discussions.It is strange that economists still are having trouble specifying Keynes's Z function nearly 70 years after the publication of the General Theory in 1936.However,Knight's theoretical analysis of uncertainty at both the micro and macro level is not as impressive as Schumpeter's analysis of uncertainty in his Theory of Economic Development(1912)or of the path breaking analysis of John Maynard Keynes in chapters 6 and 26 of the A Treatise on Probability(1921).In this latter book,Keynes operationalized a quantitative method of dealing with uncertainty(insufficient weight of the evidence,w)by means of his conventional coefficient of risk and weight,c.This coefficient allows a decision maker to incorporate uncertainty and nonadditive probabilities into a technical analysis of decision making.The only author who comes close to Keynes is D.Ellsberg with his practically identical index to measure ambiguity called rho.There are still some unanswered questions that can be asked in this area of economic thought.Why didn't Knight cite the earlier work of Joseph Schumpeter on the risk versus uncertainty distinction?Further,why didn't Keynes cite both Knight and Schumpeter in his chapters 12 ,17 and 22,where he discussed the issue of the effect of uncertainty on investment in new capital goods and on stock market speculation?

Even though the recent research in microeconomic theory has paid attention (somewhat reluctant in my opinion) to the topic of the "uncertainty", i.e. the Knightian uncertainty, it has not been successfully incorporated in the main theoretical framework, yet. The one of the evidences may be that we still cite D. Ellsberg's paper in QJE as the one of the most important work in this field: it is like citing Keynes' "General Theory" in every microeconomic paper as in 1950s and 1960s.

The book is pleasant to read: it is full of insights, usually forgotten by now, including the complemental tendency of the theoretical and empirical works in economics. The most important accomplishment is that he argued that the exisence of the "uncertainty", the event whose probablity cannot be estimated priori or from empirical data, explains the instablity of the perfect competition, the (lucklustre) justification for the monopoly and the oligopoly, and the superiority of the private property system (capitalism). It is noticable that many phenomenons metioned in the book can be still applicable now, and the last part implies the author's thought regarding to the path of the capitalism, which is explored in more depth in Schumpeter's work despite the differences in two economists' predictions.

Knight is one of the economist who lived in the transition of classical into neoclassical economics. The book predicts the emergence of more mathematical economists, but cannot escape from the influence of the former. The same thing can be said of the works of Schumpeter, Viner, and Veblen. Despite being one of the most famous economists, he and Schumpeter has no student who followed their lines of works: is it because their imaginative ways in conducting the reserach, or because of the trends in economics which trapped their students? (Stigler was a student of Knight, but which interest do their works share, except for their interests in history of economic thoughts?)

It is worth reading because it reminds of what economics is or should be about, not because it prescribes the solution which could not be found in the modern economic works. We are witnessing the transition of several countries into the private economics with the mixed results. It should be noted that Hayek's work is the starting point in this field, the transition economics or the comparative economics, but Knight's work is more appropriate, pratical, and dynamical.

Thus, if you are uncomfortable with the current economics, want to explore more idiosyncratic works in economics and think about the big picture in the path of the society, or are tempted to diverge from the dullness of the business books in your bookshelf, then this may what you have been looking for. Unless you are struck with the optimism that cannot be easily found in the present.

Frank Knight hit the ground running with his dissertation, which he published as Risk, Uncertainty, and Profit. Knight makes a simple but important distinction between quantifiable risk and uncertainty. The distinction between risk and uncertainty is important in understanding markets, profits, and entrepreneurship. Knight connects entrepreneurship with uncertainty and profit. These factors do not square well with conventional notions of perfectly competitive equilibrium.

Risk, Uncertainty, and Profit is a work of major importance. This book constitutes a serious alternative to the theories of entrepreneurship developed by Schumpeter and Kirzner. While most modern economists underemphasize entrepreneurship, Knight examines uncertainty and entrepreneurship as a way of bridging the gap between abstract theory and economic realities. Knight saw the obvious fact that we do not live in a world of perfect competition. He, like Shackle and Keynes, recognized that we must explain uncertainty if we are to ever understand how the capitalist system really works.

Knight was a major figure in the generation of interwar economists who sought to explain the dynamics of capitalism. Risk, Uncertainty, and Profit is indispensable to anyone who aims at understanding uncertainty and dynamics in microeconomics, along with the work of Schumpeter, Hayek, Coase, Kaldor, Mises, Lachmann, and Shackle.

This is the standard work in the field, give or take some stuff Keynes wrote on risk and capital.