The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice

By Francis X. Diebold; Neil A. Doherty et al. | Go to book overview

8. Reflections on Decision-making
under Uncertainty

Paul R. Kleindorfer

Chance favors the prepared Mind!
Louis Pasteur(1822–1895)


8.1. INTRODUCTION TO KNIGHTIAN UNCERTAINTY AND KUU
PROBLEMS

Frank Knight (1885–1972) completed his doctoral thesis at Cornell in 1916, at a time when great geopolitical uncertainties were unfolding in horrific ways in World War I.1 A minor revision of his thesis later became the essence of his celebrated book (Knight 1921), which remained the centerpiece of his economic contributions at the University of Chicago, where Knight joined other great economists in creating the intellectual fabric of risk, uncertainty, and profit that has become the foundation of modern finance and business strategy.

The essence of Knight's contribution was arguably his recognition that the modern firm was not just a means of solving the contracting problems that Ronald Coase eventually put to rest, but was also a mutualization institution that absorbed shocks and allowed capital recovery for investments, and that implemented and rewarded entrepreneurial initiative. In the process, Knight also made the key distinctions between management and decision making under conditions of certainty, risk and uncertainty, which is the focus of this volume.

1 I am grateful for discussions on the ideas of this paper with George B. Kleindorfer, Howard Kunreuther, and Jerry Wind, who continue to inspire my journey into KuU territory. Comments on a previous draft by Enrico Diecidue and Paul Schoemaker are gratefully acknowledge.

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