Frank Knight and uncertainty

 

How should investors deal with uncertainty? Prior to dealing with uncertainty, there has to be a definition of uncertainty relative to other terms like risk. This is an old question but one of critical importance.  The controversy or discussion about the difference between risk and uncertainty goes back all the way to Keynes and Knight in the 1920's. 

Some have viewed risk as referring to known or knowable probabilities. These would be objective probabilities. Uncertainty is where the probabilities are not known or cannot be deduced or counted and are thus subjective. This distinction was addressed by Savage in the 1950's with the answer that if subjective probabilities follow the simple axioms for any expected utility framework, the problem can be solved. That said, Knight was accepting of the combination of objective and subjective probabilities. He focused on another problem associated with uncertainty.

Knight made the distinction that risk is what can be insurable while uncertainty cannot be insured. An insurable event generally would mean that we can have data to help us determine frequency, but insurance can also be provided for events that are not countable or have subjective probabilities as long as we can define correctly the likelihoods for an event. Knight argues that uncertainty is when there is no insurance market for the event. This would be a market failure.

In Knight's view profit comes as the reward for bearing uncertainty where there is no insurance. Innovation and technological change are uncertain because it is not insurable. Management action is often uninsurable because we cannot measure properly.

Profit is the residual between revenue and costs. The cost will include the risk premium or the cost of capital. In a normal market, profits will be zero because the residual is zero after accounting for all costs. Profit is a reward for bearing uninsurable events or hazards and that would be events that can be called uncertain. Entrepreneurship is uncertain because you cannot separate bad luck from bad decisions. The outcomes cannot be determined in a way to make them objective in form that can be insured. 

While I appreciate the distinction between risk and uncertainty and the difference between objective and subjective probabilities, they're still the problem of how these subjective and objective probabilities are formed. Objective probabilities are still a problem when trying to form proper sampling. Some events do not have a large sample so there is the issue of forming subjective probabilities. These problems are present event before getting to the distinction between risk and uncertainty.