Frank Knight’s century-old wisdom on risk, uncertainty, and profit

What can we learn from a little-known economist’s book published exactly a century ago? Quite a lot. Is it useful for us today? Yes, very. It turns out that Risk, Uncertainty and Profit, published by Frank Knight in 1921, is an essential book, even if it is difficult to read. It is the first book to really define uncertainty and show what it means in decision making and how it explains profit.

Frank Knight introduced the distinction between risk and uncertainty. Risk corresponds to identically repeated events for which it is possible to establish a historical (statistical) distribution law. For example, we know exactly how many cars are stolen each year, by make, by model, and by region. This history allows us to make a prediction by calculating a probability that a particular model will be stolen. Uncertainty is the realm of novelty; it corresponds to unprecedented events for which there is no identical history (Covid-19, the invention of the Internet, etc.). This prohibits the use of statistics to calculate a probability. Uncertainty is objective: it is not due to a lack of information or the incompetence of the observer, but to the nature of the phenomenon itself. At the time the decision is made, much of the necessary information simply does not exist.

With this definition in mind, Knight turns to the person who acts in the face of uncertainty, the entrepreneur. In making a decision, the entrepreneur arbitrates between what to invest and what to expect from the investment (the return). The investment is made today for a return in the future. The question of profit arises from the observation, originally made by Cantillon, another economist, that the entrepreneur makes an arbitrage between the investment, which is made in the present and therefore certain, and the expected return, which is uncertain because it is in the future. The entrepreneur does not know whether this investment will pay off: perhaps the product will not work, perhaps it will not sell, or on the contrary, it will be unexpectedly successful. In short, the return on the investment is unpredictable.

This uncertainty means that the entrepreneur’s decision cannot be reduced to a calculation. It can be improved – for example, by calculating the cost of raw materials needed to manufacture the product – but part of the return is not calculable. That is why no Excel spreadsheet, no matter how sophisticated, can guarantee the success of an investment.

If the decision cannot be reduced to a single calculation, what is the basis for the entrepreneur to make it? According to Knight, that basis is judgment. Judgment is a subjective and circumstantial evaluation of a situation. Subjective means that someone else might have made a different assessment, and circumstantial means that the assessment would be different under different conditions. So making business decisions in the face of uncertainty is very personal, and it is impossible to lay down immutable laws. Because it’s business, it’s personal.

Photo from Jonathan Petersson on Unsplash

This observation of entrepreneurs exercising their judgment in the face of uncertainty allows Knight to explain the origin of profit. This question has long puzzled economists. We know Marx’s answer: for him, profit is the surplus that the capitalist steals from the workers, who are paid fixed amounts. Since the whole is greater than the sum of its parts, he is content to pay them and appropriate the surplus they create. Only Marx does not satisfactorily explain where this surplus comes from. That’s where Ritter comes in. The surplus is what is left over after the entrepreneur has paid all the parties who do not face uncertainty: the worker works an hour and gets paid for that hour; the banker lends $10,000 and gets paid back. If the entrepreneur does not succeed in selling the product, the wage and the loan remain legally due no matter what. Notice that while these parties are not faced with uncertainty, they are still faced with the risk, for example, that the company will go bankrupt and the wage and loan will not be paid. But they remain legally due; that is the difference between risk and uncertainty.

The entrepreneur (in the sense of the person who invests in the company) is the only one who faces uncertainty, i.e. the impossibility of knowing whether the investment will be completely lost or, on the contrary, multiplied, or some possibility in between. For Knight, profit is simply the reward for the entrepreneur’s judgment in the face of this uncertainty. The world of risk is remunerated at a fixed rate (interest on a loan, wages, etc.), while the world of uncertainty is remunerated at a variable rate, from zero to almost infinity.

In conclusion, Frank Knight’s century-old insights on risk, uncertainty, judgment, and profit continue to offer invaluable lessons for today’s entrepreneurs and decision-makers, emphasizing the enduring relevance of his pioneering work in the field of economics and business.

📖 This article is an excerpt from my book “Welcome to Uncertainty

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🇫🇷 French version of this article here.

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