What A Dead Economist Can Tell Us about Risk, Uncertainty, Profit… and Ourselves

What can we learn from the book of an almost unknown economist, published exactly one century ago? A lot. Is it useful to us in the face of current issues? 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 to show what this notion implies in decision making. And in doing so, it also tells us a lot about who we are by revealing us as fundamentally speculative.

Frank Knight introduced a 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 given model will be stolen. Uncertainty is the realm of novelty; it corresponds to unprecedented events for which there is no identical history (Covid-19, 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 to the incompetence of the observer, but to the very nature of the phenomenon. At the decision making time, much of the information needed simply does not exist.

Judgment in the face of uncertainty defines entrepreneurship

With this definition in mind, Knight turns to the person who acts in the face of uncertainty, the entrepreneur. When making a decision, the entrepreneur arbitrates between what he invests and what he expects from his 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 The question of profit arises from the observation, originally made by Cantillon, another economist, that the entrepreneur makes an arbitrage between the investment, made in the present and therefore certain, and the expected return, which is uncertain because it is situated in the future. The entrepreneur does not know if this investment will yield something: 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 not predictable.

Facing the limits of calculation: the importance of judgment

This uncertainty means that the entrepreneur’s decision cannot be reduced to a calculation. It can be improved thanks to it – for example by calculating the cost of the raw materials necessary to manufacture the product – but a part of the return is not calculable. This is why no Excel sheet, however sophisticated, will 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 assessment of a situation. Subjective means that someone else might have had a different assessment, and circumstantial means that the assessment would be different under other conditions. The entrepreneurial decision in the face of uncertainty is therefore very personal, and it is impossible to establish immutable laws. Because it’s business, it’s personal, so to speak.

Judgment in the face of uncertainty, the source of profit

This observation of entrepreneurs exercising their faculty of judgment in the face of uncertainty enables Knight to explain the origin of profit. This question has been nagging at economists for a long time. We know Marx’s answer: for him, profit is the surplus that the capitalist steals from the workers who are paid fixed amounts. The whole being greater than the sum of its parts, he is content to pay them, and to appropriate the surplus created by them. Except that Marx does not satisfactorily explain where this surplus comes from. That’s where Knight comes in. The surplus is what remains when the entrepreneur has paid all the parties who are not confronted with uncertainty: the worker works for one hour and is paid for that hour; the banker lends $10,000 and is reimbursed of that amount. If the entrepreneur does not succeed in selling the product, the wage and the loan remain legally due no matter what. Note 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 the loan will no longer be paid. But they will remain legally due; that is the difference between risk and uncertainty.

The entrepreneur (in the sense of the person who invests in the firm) is the only one who is confronted with uncertainty, i.e. the impossibility of knowing whether the investment will be entirely lost or, on the contrary, multiplied, or any possibility in between. For Knight, profit is simply the remuneration of 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.

The morality of profit

Knight’s book also sheds light on the morality of profit. This question is not new. Jesus drove the merchants out of the temple, and the Church has always regarded them with suspicion. Marx considered them as thieves. This question resurfaces regularly; recently, for example, some politicians found it scandalous that pharmaceutical laboratories could sell a Covid vaccine for $15 when it costs only $5 to manufacture. In a uncertainty-free world, the criticism would be acceptable. In a world of uncertainty, however, it ignores the fact that these laboratories have invested very large sums of money, sums that could have been entirely lost if the vaccine had not been developed, sold and distributed successfully. The difference here, the profit that is made, is the remuneration of the judgment that was made by the laboratories. Its importance is justifiable only because the sums involved could have been entirely lost. Moreover, moralists never talk about all the costly failures that laboratories, and more generally entrepreneurs, experience. Of course, the sometimes gigantic size of the profits calls for attention, but it must be remembered that the prospect of such profits is one of the motivations of entrepreneurs. In addition, society benefits greatly and in many ways from what this motivation produces (and not only for vaccines). This is what the economist Deirdre McCloskey calls the “bourgeois deal”: we let entrepreneurs make profits because we benefit in the end, as we have benefited for more than two hundred years of industrial revolution. The morality of profit, which some consider dubious, must be weighed against the morality of what this system has brought.

In addition to his contributions to an understanding of the origin of profit and the role of the entrepreneur, Knight’s work shows that economics is not a purely material domain, separated from moral and social issues. On the contrary, in another book, Ethics of competition, he insisted on the profoundly human nature of economic action, which is surrounded by an ethical framework.

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