Risk, Uncertainty and Profit
By Frank H. Knight
2002/04 - Beard Books
1587981262 - Paperback - Reprint - 447 pp.
This book remains one of the most interesting readings in economics available.
Frank H. Knight, one of the 20th century's giants in the field of economics, has given us a landmark book in the history of economic theory. A classic in its field, it was listed in the 1998 Forbes reading list as elucidating between insurable risk and true uncertainty. In fact, that is the dominant theme of the book, developing the theory of "risk, uncertainty, and profit" from the common sense view of production. The writer is careful to state that the book is a study in "pure theory" focused on the entrepreneur as the central figure in a free enterprise system whose goal is profit. He was among the first economists to expound on the law of variable proportions in the theory of production.
There is little that is fundamentally new in this book. It represents an attempt to state the essential principles of the conventional economic doctrine more accurately, and to show their implications more clearly, than has previously been done. That is, its object is refinement, not reconstruction; it is a study in "pure theory." The motive back of its presentation is twofold. In the first place, the writer cherishes, in the face of the pragmatic, philistine tendencies of the present age, especially characteristic of the thought of our own country, the hope that careful, rigorous thinking in the field of social problems does after all have some significance for human weal and woe. In the second place, he has a feeling that the "practicalism" of the times is a passing phase, even to some extent a pose; that there is a strong undercurrent of discontent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach a clearer understanding of the meaning of terms and dogmas which pass current as representing ideas. For the first of these assumptions a few words of elaboration or defense may be in place, in anticipation of the essay itself.
The "practical" justification for the study of general economics is a belief in the possibility of improving the quality of human life through changes in the form of organization of want-satisfying activity. More specifically, most projects of social betterment involve the substitution of some more consciously social or political form of control for private property and individual freedom of contract. The assumption underlying such studies as the present is that changes of this character will offer greater prospect of producing real improvement if they are carried out in the light of a clear understanding of the nature and tendencies of the system which it is proposed to modify or displace. The essay, therefore, endeavors to isolate and define the essential characteristics of free enterprise as a system or method of securing and directing cooperative effort in a social group. As a necessary condition of success in this endeavor it is assumed that the description and explanation of phenomena must be radically separated from all questions of defense or criticism of the system under examination. By means of first showing what the system is, it is hoped that advance may be made toward discovering what such a system can, and what it cannot, accomplish. A closely related aim is that of formulating the data of the problem of economic organization, the unchangeable materials with which, and conditions under which, any machinery of organization has to work. A sharp and clear conception of these fundamentals is viewed as a necessary foundation for answering the question as to what is reasonably to be expected of a method of organization, and hence of whether the system as such is to be blamed for the failure to achieve ideal results, of where if at all it is at fault, and the sort of change or substitution which offers sufficient chance for improvement to justify experimentation.
The net result of the inquiry is by no means a defense of the existing order. On the contrary, it is probably to emphasize the inherent defects of free enterprise. But it must be admitted that careful analysis also emphasizes the fundamental difficulties of the problem and the fatuousness of over-sanguine expectations from mere changes in social machinery. Only this foundation-laying is within the scope of this study, or included within the province of economic theory. The final verdict on questions of social policy depends upon a similar study of other possible systems of organization and a comparison of these with free enterprise in relation to the tasks to be accomplished. This one "conclusion" may be hazarded, that no one mode of organization is adequate or tolerable for all purposes in all fields. In the ultimate society, no doubt, every conceivable type of organization machinery will find its place, and the problem takes the form of defining the tasks and spheres of social endeavor for which each type is best adapted.
The particular technical contribution to the theory of free enterprise which this essay purports to make is a fuller and more careful examination of the rôle of the entrepreneur or enterpriser, the recognized "central figure" of the system, and of the forces which fix the remuneration of his special function. The problem of profit was suggested to the writer as a suitable topic for a doctoral dissertation in the spring of 1914 by Dr. Alvin Johnson, then Professor of Economics in Cornell University. The study was chiefly worked out under the direction of Professor Allyn A. Young after Dr. Johnson left Cornell. My debt to these two teachers I can only gratefully acknowledge. Since the acceptance of the essay as a thesis at Cornell in June, 1916, and its submission in the Hart, Schaffner & Marx competition in 1917, it has been entirely rewritten under the editorial supervision of Professor J. M. Clark, of the University of Chicago. I have also profited much by discussions with Professor C. O. Hardy, my colleague at the same institution, and by access to his unpublished "Readings on Risk and Risk-Bearing." Professor Jacob Viner, of the University of Chicago, has kindly read the proof of the entire work. My obligations to various economists through their published work are very inadequately shown by text and footnote references, but are too comprehensive and indefinite to express in detail.
F. H. KNIGHT
From Turnarounds and Workouts, December 15, 2002
The tenets Frank H. Knight sets out in this, his first book, have become an integral part of modern economic theory. Still readable today, it was included as a classic in the 1998 Forbes reading list. The book grew out of Knight's 1917 Cornell University doctoral thesis, which took second prize in an essay contest that year sponsored by Hart, Schaffner and Marx. In it, he examined the relationship between knowledge on the part of entrepreneurs and changes in the economy. He, quite famously, distinguished between two types of change, risk and uncertainty, defining risk as randomness with knowable probabilities and uncertainty as randomness with unknowable probabilities. Risk, he said, arises from repeated changes for which probabilities can be calculated and insured against, such as the risk of fire. Uncertainty arises from unpredictable changes in an economy, such as resources, preferences, and knowledge, changes that cannot be insured against. Uncertainty, he said "is one of the fundamental facts of life."
One of the larger issues of Knight's time was how the entrepreneur, the central figure in a free enterprise system, earns profits in the face of competition. It was thought that competition would reduce profits to zero across a sector because any profits would attract more entrepreneurs into the sector and increase supply, which would drive prices down, resulting in competitive equilibrium and zero profit.
Knight argued that uncertainty itself may allow some entrepreneurs to earn profits despite this equilibrium. Entrepreneurs, he said, are forced to guess at their expected total receipts. They cannot foresee the number of products they will sell because of the unpredictability of consumer preferences. Still, they must purchase product inputs, so they base these purchases on the number of products they guess they will sell. Finally, they have to guess the price at which their products will sell. These factors are all uncertain and impossible to know. Profits are earned when uncertainty yields higher total receipts than forecasted total receipts. Thus, Knight postulated, profits are merely due to luck. Such entrepreneurs who "get lucky" will try to reproduce their success, but will be unable to because their luck will eventually turn.
At the time, some theorists were saying that when this luck runs out, entrepreneurs will then rely on and substitute improved decision making and management for their original entrepreneurship, and the profits will return. Knight saw entrepreneurs as poor managers, however, who will in time fail against new and lucky entrepreneurs. He concluded that economic change is a result of this constant interplay between new entrepreneurial action and existing businesses hedging against uncertainty by improving their internal organization.
Frank H. Knight has been called "among the most broad-ranging and influential economists of the twentieth century" and "one of the most eclectic economists and perhaps the deepest thinker and scholar American economics has produced." He stands among the giants of American economists that include Schumpeter and Viner. His students included Nobel Laureates Milton Friedman, George Stigler and James Buchanan, as well as Paul Samuelson. At the University of Chicago, Knight specialized in the history of economic thought. He revolutionized the economics department there, becoming one the leaders of what has become known as the Chicago School of Economics. Under his tutelage and guidance, the University of Chicago became the bulwark against the more interventionist and anti-market approaches followed elsewhere in American economic thought. He died in 1972.
Model of how economic problems should be analyzed, March 8, 2001
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 fluctuations 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 classic study has a long history: first published in 1921, reissued 1933, reprinted 1948 and 1957, and cited in Books for College Libraries, 3d ed. 1971. Annotation c. Book News, Inc.,Portland, OR
Get this classic back in print!, March 1, 2001
This is the standard work in the field, give or take some stuff Keynes wrote on risk and capital.
Frank H. Knight was one of the founders of the so-called Chicago school of economics, of which Milton Friedman and George Stigler were the leading members from the fifties to the eighties. Knight made his reputation with his book Risk, Uncertainty, and Profit, which was based on his Ph.D. dissertation. In it Knight set out to explain why perfect competition would not necessarily eliminate profits. His explanation was "uncertainty," which Knight distinguished from risk. According to Knight risk refers to a situation where the probability of an outcome could be determined, and therefore, the outcome could be insured against. Uncertainty, by contrast, referred to an event whose probability could not be known. Knight argued that even in long-run equilibrium, entrepreneurs would earn profits as a return for their putting up with uncertainty. Knight's distinction between risk and uncertainty is still taught in economics classes today. Knight made three other important contributions to economics. One was The Economic Organization, a set of lecture notes originally published in 1933; his famous article, "Some Fallacies in the Interpretation of Social Cost; " and his work on capital theory in the thirties.
Knight was an economics professor at the University of Chicago from 1927 until 1955, after which he was emeritus professor until his death.