Academic journal article Economic Inquiry

Frank Knight on Risk, Uncertainty, and the Firm: A New Interpretation

Academic journal article Economic Inquiry

Frank Knight on Risk, Uncertainty, and the Firm: A New Interpretation

Article excerpt

I. INTRODUCTION

For decades now, economists have struggled to interpret Frank Knight's Risk, Uncertainty, and Profit. Like a handful of other classic texts--Das Kapital and The General Theory come to mind--it has produced nearly as much confusion as inspiration, nearly as much misinterpretation as interpretation. Risk, Uncertainty, and Profit is a brilliant book. But it is also idiosyncratic in scope and method. Worse yet, in the eyes of the modern economist, it is deeply philosophical. The resulting combination of bedazzlement and puzzlement has led successive interpreters to commit a variant of the sin supposedly characteristic of eighteenth-century Whig historians: they have interpreted the ancient text in the narrow light of their own generation's favored theories and received categories of analysis. These interpreters feel free to ignore those of Knight's musings that fail to fit the mold, marking them down to Knight's own confusions.

The issues here are not purely ones of intellectual history. The issues Knight addressed remain as important and divisive today as when he wrote. LeRoy and Singell |1987~ suggest the importance of Knight's conception of uncertainty to macroeconomic modeling. Moreover, the award of the 1991 Nobel Prize to Ronald Coase signals the profession's increasing interest in the firm qua organization rather than qua production function.(1) Much of the third part of Risk, Uncertainty, and Profit is devoted to the very issues Coase addressed in his seminal 1937 article: the rationale for the business firm. We argue that, although much less well known to the profession than Coase's work, Knight's oft-misunderstood analysis of the firm has much to contribute to today's literature.

Risk, Uncertainty, and Profit is firmly grounded in static neoclassical theory, and the second of its three parts is a forceful restatement of the theory of perfect competition. Yet, the book is very much a challenge to neoclassical theory, especially so in Parts I and III. This tension--if one can call it that--explains in part the peculiar pattern of misinterpretation that has plagued the text. Almost since the beginning, economists have sought to comprehend Knight's troubling discussion of risk, uncertainty, and organization by casting it in the framework of neoclassical thinking popular in their own day.

This tendency to Whig history has led to a succession of differing interpretations. For instance, Knight's distinction between risk and uncertainty has been taken to differentiate between the measurability/unmeasurability or objectivity/subjectivity of probability, or between the insurability/uninsurability of probabilistic outcomes. An early generation of interpretations took the position that by risk Knight meant situations in which one could assign probabilities to outcomes and by uncertainty situations in which one could not.(2) This way of framing the distinction fit in well with the rhetoric of the debate between proponents of an objective theory of probability and adherents to subjective probability theory. Moreover, as the latter had effectively routed the former (at least in principle)(3) within the realm of theoretical economics, this framing of the distinction made it possible to ignore situations of uncertainty entirely: for if probability consists in a decision-maker's subjective assessment, then there is no state of the world whose probability cannot be articulated.(4) By definition, all probabilistic situations are matters of risk.

Although this interpretation has passed so deeply into the consciousness of economists that it remains dominant today,(5) LeRoy and Singell |1987~ have recently produced an interpretation that is much closer to the mark. In their view, Knight understood perfectly well that agents could form subjective probability assessments of any situation. The distinction Knight actually intended was that between situations in which insurance markets can operate smoothly (risk) and situations in which insurance markets would collapse because of moral hazard and adverse selection (uncertainty). …

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