Risk, Uncertainty and Profit

Risk, Uncertainty and Profit

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by Frank H. Knight
     
 

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This revolutionary work taught the world how to systematically distinguish between risk — randomness with knowable probabilities — and uncertainty — randomness with unknowable probabilities — in order to accurately and properly ascertain a venture's potential profitability. Knight's methodology served as the foundation of the Chicago School of… See more details below

Overview

This revolutionary work taught the world how to systematically distinguish between risk — randomness with knowable probabilities — and uncertainty — randomness with unknowable probabilities — in order to accurately and properly ascertain a venture's potential profitability. Knight's methodology served as the foundation of the Chicago School of Economics.

Product Details

ISBN-13:
9780486147932
Publisher:
Dover Publications
Publication date:
02/10/2012
Sold by:
Barnes & Noble
Format:
NOOK Book
Pages:
448
File size:
1 MB

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Risk, Uncertainty and Profit


By Frank H. Knight

Dover Publications, Inc.

Copyright © 2006 Dover Publications, Inc.
All rights reserved.
ISBN: 978-0-486-14793-2



CHAPTER 1

THE PLACE OF PROFIT AND UNCERTAINTY IN ECONOMIC THEORY

ECONOMICS, or more properly theoretical economics, is the only one of the social sciences which has aspired to the distinction of an exact science. To the extent that it is an exact science it must accept the limitations as well as share the dignity thereto pertaining, and it thus becomes like physics or mathematics in being necessarily somewhat abstract and unreal. In fact it is different from physics in degree, since, though it cannot well be made so exact, yet for special reasons it secures a moderate degree of exactness only at the cost of much greater unreality. The very conception of an exact science involves abstraction; its ideal is analytic treatment, and analysis and abstraction are virtually synonyms. We have given us the task of reducing to order a complex mass of interrelated changes, which is to say, of analyzing them into uniformities of sequence or behavior, called laws, and the isolation of the different elementary sequences for separate study.

Sometimes the various elementary constituents of our complex phenomenon are met with in nature in isolation complete or partial, and sometimes artificial experiments can be devised to present them either alone or with attendant conditions subject to control. The latter is, of course, the characteristic procedure of physical science. Its application to the study of industrial society is, however, generally impracticable. Here we must commonly search for manifestations of the various factors in our complex, under varying associations, or rely upon intuitive knowledge of general principles and follow through the workings of individual chains of sequence by logical processes.

The application of the analytic method in any class of problems is always very incomplete. It is never possible to deal in this way with a very large proportion, numerically speaking, of the vast complexity of factors entering into a normal real situation such as we must cope with in practical life. The value of the method depends on the fact that in large groups of problem situations certain elements are common and are not merely present in each single case, but in addition are both few in number and important enough largely to dominate the situations. The laws of these few elements, therefore, enable us to reach an approximation to the law of the situation as a whole. They give us statements of what "tends" to hold true or "would" hold true under "ideal" conditions, meaning merely in a situation where the numerous and variable but less important "other things" which our laws do not take into account were entirely absent.

Thus, in physics, the model and archetype of an exact science of nature, a relatively small and workable number of laws or principles tell us what would happen if simplified conditions be assumed and all disturbing factors eliminated. The simplified conditions include specifications as to dimensions, mass, shape, smoothness, rigidity, elasticity and properties generally of the objects worked with, specifications usually quite impossible to realize in fact, yet absolutely necessary to make, while the "disturbing factors" are simply anything not included in the specifications, and their actual elimination is probably equally impossible to realize, and, again, equally necessary to assume. Only thus could we ever obtain "laws," descriptions of the separate elements of phenomena and their separate behavior. And while such laws, of course, never accurately hold good in any particular case, because they are incomplete, not including all the elements in the case, yet they enable us to deal with practical problems intelligently because they are approximately true and we know how to discount their incompleteness. Only by such approximations, reached by dealing analytically with the more important and more universal aspects of phenomena, could we ever have attained any intelligent conception of the behavior of masses of matter in motion and secured our present marvelous mastery over the forces of nature.

In a similar way, but for various reasons not so completely and satisfactorily, we have developed a historic body of theoretical economics which deals with "tendencies" ; i.e., with what "would" happen under simplified conditions never realized, but always more or less closely approached in practice. But theoretical economics has been much less successful than theoretical physics in making the procedure useful, largely because it has failed to make its nature and limitations explicit and clear. It studies what would happen under "perfect competition," noting betimes respects in which competition is not perfect ; but much remains to be done to establish a systematic and coherent view of what is necessary to perfect competition, just how far and in what ways its conditions deviate from those of real life and what "corrections" have accordingly to be made in applying its conclusions to actual situations.

The vague and unsettled state of ideas on this subject is manifest in the difference of opinion rife among economists as to the meaning and use of theoretical methods. At one extreme we have mathematical economists and pure theorists to whom little if anything outside of a closed system of deductions from a very small number of premises assumed as universal laws is to be regarded as scientific economics at all. At the other extreme there is certainly a strong and perhaps growing tendency to repudiate abstraction and deduction altogether, and insist upon a purely objective, descriptive science. And in between are all shades of opinion.

In the present writer's view the correct "middle way" between these extreme views, doing justice to both, is not hard to find. An abstract deductive system is only one small division of the great domain of economic science, but there is opportunity and the greatest necessity for cultivating that field. Indeed, in our analogy, theoretical mechanics is a very small section of the science of physical nature; but it is a very fundamental section, in a sense the "first" of all, the foundation and prerequisite of those that follow. And this also may very well hold good of a body of "pure theory" in economics; it may be that a small step, but the first step, toward a practical comprehension of the social system is to isolate and follow out to their logical conclusion a relatively small number of fundamental tendencies discoverable in it. There is abundant need for the use of both deduction and induction in economics as in other sciences, if indeed the two methods are theoretically separable. As Mill has well argued we must reason deductively as far as possible, always collating our conclusions with observed facts at every stage. Where the data are too complex to handle in this way induction must be applied and empirical laws formulated, to be connected deductively with the general principles of "ethology" (we should now say simply "human behavior"). Emphasis being laid on the provisos, in both cases, that in using deduction the conclusions must be constantly checked with facts by observation and premises revised accordingly, while the empirical laws resulting from induction must in turn be shown to follow from the general principles of the science before they can be credited with much significance or dependability, we see that there is little divergence left between the two methods.

The method of economics is simply that of any field of inquiry where analysis is in any degree applicable and anything more than mere description possible. It is the scientific method, the method of successive approximations. The study will begin with a theoretical branch dealing with only the most general aspects of the subject matter, and proceed downward through a succession of principles applicable to more and more restricted classes of phenomena. How far the process is carried will be a matter of taste and of the practical requirements of any problem. In science generally it does not pay to elaborate laws of a very great degree of accuracy of detail. When the number of factors taken into account in deduction becomes large, the process rapidly becomes unmanageable and errors creep in, while the results lose in generality of application more significance than they gain by the closeness of approximation to fact in a given case. 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.

The theoretical method in its pure form consists, then, in the complete and separate study of general principles, with the rigid exclusion of all fluctuations, modifications, and accidents of all sorts due to the influence of factors less general than those under investigation at any particular stage of the inquiry. Our question relates to the advisability of using this method in a tolerably rigid form in economics. The answer to this question depends on whether in the phenomena to be studied general principles can in fact be found of sufficient constancy and importance to justify their careful isolation and separate study. The writer is strongly of the opinion that the question must be answered affirmatively. Economics is the study of a particular form of organization of human wantsatisfying activity which has become prevalent in Western nations and spread over the greater part of the field of conduct. It is called free enterprise or the competitive system. It is obviously not at all completely or perfectly competitive, but just as indisputably its general principles are those of free competition. Under these circumstances the study, as a first approximation, of a perfectly competitive system, in which the multitudinous degrees and kinds of divergences are eliminated by abstraction, is clearly indicated. The method is particularly indicated in a practical sense because our most important questions of social policy hinge directly upon the question of the character of the "natural" results of competition, and take the form of queries as to whether the tendencies of competition are to be furthered and supplemented or obstructed and replaced.

That such a theoretical first approximation is indicated in a theoretical sense, that it is the natural logical way of going at the problem, conforming to the workings of our thought processes, is sufficiently evidenced by the fact that this is what economists have always in fact done, ever since there has been such a science or such a social system to be studied. They have, to be sure, been criticized for doing it, and severely. But in the present writer's judgment theorists of the past and present are to be justly criticized not for following the theoretical method and studying a simplified and idealized form of competitive organization, but for not following it in a sufficiently self-conscious, critical, and explicit way. In their discussions of methodology the historic economists have, indeed, been as clear and explicit as could be desired, but in the use of the method as much cannot, unfortunately, be said.

It should go without saying that in the use of the scientific method of reasoning from simplified premises, it is imperative that it be clear to the reasoner and be made unmistakable to those who use his work what his procedure is and what presuppositions are involved. Two supreme difficulties have underlain controversies regarding method in the past. The first is the strong aversion of the masses of humanity, including even a large proportion of "scholars," to all thinking in general terms. The second difficulty, on the other side, is the fact referred to above, that the persons employing methods of approximation in economics have not themselves adequately and always recognized, and still less have they made clear to their readers, the approximate character of their conclusions, as descriptions of tendency only, but have frequently hastened to base principles of social and business policy upon very incomplete data. The evil results of the failure to emphasize the theoretical character of economic speculation are apparent in every field of practical economics. The theorist not having definite assumptions clearly in mind in working out the "principles," it is but natural that he, and still more the practical workers building upon his foundations, should forget that unreal assumptions were made, and should take the principles over bodily, apply them to concrete cases, and draw sweeping and wholly unwarranted conclusions from them. The clearly untenable and often vicious character of such deductions naturally works to discredit theory itself. This, of course, is wrong; we do not allow perpetual motion schemes to discredit theoretical mechanics, which is built upon the assumption of perpetual motion at every stage. But in economics a distrust of general principles, fatal as it is to clear thinking, will be inevitable as long as the postulates of theory are so nebulous and shifting. They can hardly be made sufficiently explicit; it is imperative that the contrast between these simplified assumptions and the complex facts of life be made as conspicuous and as familiar as has been done in mechanics.

The present essay is an attempt in the direction indicated above. We shall endeavor to search out and placard the unrealities of the postulates of theoretical economics, not for the purpose of discrediting the doctrine, but with a view to making clear its theoretical limitations. There are several reasons why the approximate character of theoretical economic laws and their inapplicability without empirical correction to real situations should be especially emphasized as compared, for instance, with those of mechanics. The first reason is historical and has already been indicated. The limitations of the results have not always been clear, and theorists themselves as well as writers in practical economics and statecraft have carelessly used them without regard for the corrections necessary to make them fit concrete facts. Policies must fail, and fail disastrously, which are based on perpetual motion reasoning without the recognition that it is such.

In the second place, the allowances and corrections necessary in the case of theoretical economics are vastly greater than in the case of mechanics, and the importance of not losing sight of them is correspondingly accentuated. The general principles do not bring us so close to reality; there is a larger proportion of factors in an economic situation which are of the variable and fluctuating sort.

Again, in spite of the greater contrast between theory and practice in the study of the mechanics of competition, as compared with the mechanics of matter and motion, the contrast is less familiar and more easily overlooked. Our race has been observing and handling in a rude way the latter type of phenomena ever since it has lived on the earth, while competitive relations among men were established only a few generations ago. In consequence the habit of clear thinking according to scientific method, the use of hypotheses and separation of fundamental principles from the accidents of particular instances, has become in some measure built up in the minds of at least a respectable body of the more cultivated division of the race. Perhaps it is even in some degree instinctive in certain strains.


(Continues...)

Excerpted from Risk, Uncertainty and Profit by Frank H. Knight. Copyright © 2006 Dover Publications, Inc.. Excerpted by permission of Dover Publications, Inc..
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