Risk, Uncertainty and Profit

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Summary: Before Knight there was Schumpeter and Keynes
Review: 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?


Rating:
Summary: Model of how economic problems should be analyzed
Review: 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).

Rating:
Summary: Model of how economic problems should be analyzed
Review: 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).

Rating:
Summary: Get this classic back in print!
Review: This is the standard work in the field, give or take some stuff Keynes wrote on risk and capital.