Knightian uncertainty

In economics, Knightian uncertainty is risk that is immeasurable, not possible to calculate.

Knightian uncertainty is named after University of Chicago economist Frank Knight (1885–1972), who distinguished risk and uncertainty in his work Risk, Uncertainty, and Profit:^[1]

"Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all."

Related concepts

Common-cause and special-cause

The difference between predictable variation and unpredictable variation is one of the fundamental issues in the philosophy of probability, and different probability interpretations treat predictable and unpredictable variation differently. The distinction and debate has a long history, referred to as and discussed at common-cause and special-cause.

Ellsberg paradox

The Ellsberg paradox is based on the difference between these two types of risk, and the problems it poses for utility theory – one is faced with an urn that contains 30 red balls and 60 balls that are either all yellow or all black, and one then draws a ball from the urn. This poses both uncertainty – whether the non-red balls are all yellow or all black – and probability – whether the ball is red or non-red, which is ⅓ vs. ⅔. Expressed preferences in choices faced with this situation reveal that people do not treat these risks the same. This is also termed "ambiguity aversion".

Controversy

Nassim Nicholas Taleb has developed the Black swan theory where there is no distinction between any different kinds of uncertainty.

In his book The Black Swan, in the section subtitled "The uncertainty of the nerd", he writes:

In real life you do not know the odds; you need to discover them, and the sources of uncertainty are not defined. Economists, who do not consider what was found by noneconomists worthwhile, draw an artificial distinction between Knightian risk (which you can compute) and Knightian uncertainty (which you cannot compute), after one Frank Knight, who rediscovered the notion of unknown uncertainty and did a lot of thinking but perhaps never took risks, or perhaps lived in the vicinity of a casino. Had he taken financial or economic risk he would have realized that these "computable" risks are largely absent from real life! They are laboratory contraptions.

References