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Market volatility has undermined the credibility of models in macro-economics and finance. Lacking accurate maps to navigate the current turbulence, investors, scholars, and managers are spending more time pondering uncertainty and risk. These topics can lure even hard-nosed thinkers into fuzzy rumination–recall Donald Rumsfeld’s distinction between known unknowns and unknown unknowns. In these unsettled times, it worthwhile revisiting the contribution of Frank Knight, an economist who was among the earliest and most penetrating analysts of what uncertainty and risk meant, and how they influenced a firm’s ability to make a profit.
Although few people recognize his name today, Frank Knight was one of the most influential economists of the last century. Knight joined the economics faculty of the University of Chicago full-time in 1928, and remained there until his retirement in 1972. In his forty four years, he co-founded and shaped the “Chicago School” of economics that produced many of the Twentieth Century’s giants of economics, including Milton Friedman, Ronald Coase, and Gary Becker, among others. In the 1990s alone, more than half the economists who won Nobel prizes had either taught or studied at Chicago, and Knight himself supervised four future Nobel prize winners (Milton Friedman, George Stigler, James Buchanan and Paul Samuelson).
Knight did not descend from academic stock, and nothing in his early life marked him as a future leader in the field of economics. Born in rural Illinois in 1885, Knight was the eldest of eleven children. The burdens of farm life delayed his graduation from high school, and he was twenty-six years old when he received a college degree from Milligan College in Tennessee. Knight began a PhD program in philosophy at Cornell, but his professors shunted him to economics, after they decided he was too skeptical for philosophy. At a time when many social scientists grasp their models with a certainty that borders on religious faith, it is refreshing to picture a student who entered economics because he was too skeptical for philosophy, the field that invented the term.
Knight largely influenced economics through his teaching. At first glance, this is surprising, since Knight defies the stereotype of a great teacher. A former student, Don Patinkin, described Knight’s style as “leaning back on the back of a chair, occasionally puffing on a corn-cob pipe-and rambling on in a high-pitched voice and in a disjointed manner on mysterious issues…after a few such bewildering experiences, I gave up in despair.” Patinkin sat through Knight’s course three times before he full appreciated the value of the experience. Knight succeeded as a teacher not by winning acolytes to his preferred theory, but by inculcating in his students with a radical skepticism to question everything and explore the assumptions that lay below their models.
Knight’s scepticism did not prevent him from taking a stand on the foundational topics in economics, and indeed his doctoral dissertation, entitled Risk, Uncertainty, and Profit tackled some of the thorniest questions that face economists, investors, and managers: What is uncertainty? How does it differ from risk? How can we use past experience to formulate expectations about the future? How do economic profits come into existence? What are the limits of prediction?
Given Knight’s stature and the topics he addressed, it is surprising that his magnum opus remains a hidden in plain cite. Scholars footnote it frequently, but like many classics it is cited more than read, and read more than understood. By and large, economists have reduced Knight’s expansive ruminations on risk and uncertainty to a simple dichotomy between quantifiable and unquantifiable probabilities.
Risk, according to this simplistic view, refers to randomness when the probabilities can be known in advance. The roll of a die or flip of a coin generate risk. Uncertainty, in contrast, describes randomness where we cannot know the probabilities in advance. What are the odds that we will discover a vaccine against AIDS in this decade? What is the probability that terrorists will explode a dirty bomb in a major city? Unprecedented events give us no basis for estimating probabilities.
Knight’s critics have dismissed this distinction as unclear, or much worse uninteresting. According to this critique, decision-makers who lack the basis for objective probabilities before hand simply make their best guess (assign ex ante subjective probabilities, in the parlance) to various outcomes, and get on with it. Once we view confidence in various probability assessments as lying on a spectrum ranging from dead certain (an honest die) to completely subjective (contact with extraterrestrials), Knight’s bright line distinguishing between risk and uncertainty dims and arguably fades altogether.
This critique cuts, but only by attacking a caricature of Knight’s point of view. To be fair, I must admit that some of Knight’s misunderstanding is self-inflicted. His opaque and meandering prose befuddles the casual reader. The following sentences, chosen at random from Risk, Uncertainty, and Profit (VII, section 6), illustrate Knight’s prose style. “The first datum for the study of knowledge and behavior is the fact of consciousness itself. Apparently the higher mental operations of reason are different only in degree, only elaborations of what is inherent in the first spark of “awareness.” The essence of mentality from a functional standpoint seems to be its forward-looking character. ” No one would confuse this with beach reading.
Knight’s prose demands a careful reading, but repays the effort. My next post will discuss Knight’s nuanced and powerful distinction between risk and uncertainty.
Tags: Chicago School, Chicago School of Economics, economic models, Frank Knight, profit, risk, skepticism, uncertainty
