Knightian uncertainty

Last updated

In economics, Knightian uncertainty is a lack of any quantifiable knowledge about some possible occurrence, as opposed to the presence of quantifiable risk (e.g., that in statistical noise or a parameter's confidence interval). The concept acknowledges some fundamental degree of ignorance, a limit to knowledge, and an essential unpredictability of future events.

Contents

Knightian uncertainty is named after University of Chicago economist Frank Knight (1885–1972), who distinguished risk and uncertainty in his 1921 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."

In this matter Knight's own views were widely shared by key economists [2] in the 1920s and 1930s who played a key role distinguishing the effects of risk from uncertainty. They were particularly concerned with the different impact on human behavior as economic agents. Entrepreneurs invest for quantifiable risk and return; savers may mistrust potential future inflation.

Whilst Frank Knight's seminal book [1] elaborated the problem, his focus was on how uncertainty generates imperfect market structures and explains actual profits. Work on estimating and mitigating uncertainty was continued by G. L. S. Shackle who later followed up with Potential Surprise Theory. [3] [4] However, the concept is largely informal and there is no single best formal system of probability and belief to represent Knightian uncertainty. Economists and management scientists continue to look at practical methodologies for decision under different types of uncertainty.

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 debate about the distinction has a long history.

Ellsberg paradox

The Ellsberg paradox is based on the difference between these two types of imperfect knowledge, 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 1⁄3 vs. 2⁄3. Expressed preferences in choices faced with this situation reveal that people do not treat these types of imperfect knowledge the same. This difference in treatment is also termed "ambiguity aversion".

Black swan events

A black swan event, as analyzed by Nassim Nicholas Taleb, is an important and inherently unpredictable event that, once occurred, is rationalized with the benefit of hindsight. Another position of the black swan theory is that appropriate preparation for these events is frequently hindered by the pretense of knowledge of all the risks; in other words, Knightian uncertainty is presumed to not exist in day-to-day affairs, often with disastrous consequences. Taleb asserts that Knightian risk does not exist in the real world, and instead finds gradations of computable risk. [5]

Effectuation

Saras Sarasvathy has proposed effectuation as a way to manage Knightian Uncertainty, based on her study of serial entrepreneurs, and summarised her findings in five principles:Brian D Smith (2014-07-25). "Managing Pharma's Uncertainty".

See also

Related Research Articles

<span class="mw-page-title-main">Uncertainty</span> Situations involving imperfect or unknown information

Uncertainty or incertitude refers to epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to physical measurements that are already made, or to the unknown. Uncertainty arises in partially observable or stochastic environments, as well as due to ignorance, indolence, or both. It arises in any number of fields, including insurance, philosophy, physics, statistics, economics, finance, medicine, psychology, sociology, engineering, metrology, meteorology, ecology and information science.

<span class="mw-page-title-main">Value at risk</span> Estimated potential loss for an investment under a given set of conditions

Value at risk (VaR) is a measure of the risk of loss of investment/Capital. It estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses.

<span class="mw-page-title-main">Frank Knight</span> American economist (1885–1972)

Frank Hyneman Knight was an American economist who spent most of his career at the University of Chicago, where he became one of the founders of the Chicago School.

Common and special causes are the two distinct origins of variation in a process, as defined in the statistical thinking and methods of Walter A. Shewhart and W. Edwards Deming. Briefly, "common causes", also called natural patterns, are the usual, historical, quantifiable variation in a system, while "special causes" are unusual, not previously observed, non-quantifiable variation.

<span class="mw-page-title-main">Nassim Nicholas Taleb</span> Lebanese-American author (born 1960)

Nassim Nicholas Taleb is a Lebanese-American essayist, mathematical statistician, former option trader, risk analyst, and aphorist. His work concerns problems of randomness, probability, complexity, and uncertainty.

In decision theory, the Ellsberg paradox is a paradox in which people's decisions are inconsistent with subjective expected utility theory. John Maynard Keynes published a version of the paradox in 1921. Daniel Ellsberg popularized the paradox in his 1961 paper, "Risk, Ambiguity, and the Savage Axioms". It is generally taken to be evidence of ambiguity aversion, in which a person tends to prefer choices with quantifiable risks over those with unknown, incalculable risks.

Entrepreneurial economics is the field of study that focuses on the study of entrepreneur and entrepreneurship within the economy. The accumulation of factors of production per se does not explain economic development. They are necessary factors of production, but they are not sufficient for economic growth.

George Lennox Sharman Shackle was an English economist. He made a practical attempt to challenge classical rational choice theory and has been characterised as a "post-Keynesian", though he is influenced as well by Austrian economics. Much of his work is associated with the Dempster–Shafer theory of evidence.

Financial risk modeling is the use of formal mathematical and econometric techniques to measure, monitor and control the market risk, credit risk, and operational risk on a firm's balance sheet, on a bank's accounting ledger of tradeable financial assets, or of a fund manager's portfolio value; see Financial risk management. Risk modeling is one of many subtasks within the broader area of financial modeling.

In decision theory and economics, ambiguity aversion is a preference for known risks over unknown risks. An ambiguity-averse individual would rather choose an alternative where the probability distribution of the outcomes is known over one where the probabilities are unknown. This behavior was first introduced through the Ellsberg paradox.

<span class="mw-page-title-main">Black swan theory</span> Theory of response to surprise events

The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The term is based on a Latin expression which presumed that black swans did not exist. The expression was used until around 1697 when Dutch mariners saw them in Australia. After this, the term was reinterpreted to mean an unforeseen and consequential event.

The RiskMetrics variance model was first established in 1989, when Sir Dennis Weatherstone, the new chairman of J.P. Morgan, asked for a daily report measuring and explaining the risks of his firm. Nearly four years later in 1992, J.P. Morgan launched the RiskMetrics methodology to the marketplace, making the substantive research and analysis that satisfied Sir Dennis Weatherstone's request freely available to all market participants.

<i>The Black Swan: The Impact of the Highly Improbable</i> 2007 book by Nassim Nicholas Taleb

The Black Swan: The Impact of the Highly Improbable is a 2007 book by Nassim Nicholas Taleb, who is a former options trader. The book focuses on the extreme impact of rare and unpredictable outlier events—and the human tendency to find simplistic explanations for these events, retrospectively. Taleb calls this the Black Swan theory.

<span class="mw-page-title-main">Taleb distribution</span> Type of probability distribution in economics

In economics and finance, a Taleb distribution is the statistical profile of an investment which normally provides a payoff of small positive returns, while carrying a small but significant risk of catastrophic losses. The term was coined by journalist Martin Wolf and economist John Kay to describe investments with a "high probability of a modest gain and a low probability of huge losses in any period."

<span class="mw-page-title-main">Risk</span> Possibility of something bad happening

In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value, often focusing on negative, undesirable consequences. Many different definitions have been proposed. One international standard definition of risk is the "effect of uncertainty on objectives".

A Treatise on Probability, published by John Maynard Keynes in 1921, provides a much more general logic of uncertainty than the more familiar and straightforward 'classical' theories of probability. This has since become known as a "logical-relationist" approach, and become regarded as the seminal and still classic account of the logical interpretation of probability, a view of probability that has been continued by such later works as Carnap's Logical Foundations of Probability and E.T. Jaynes Probability Theory: The Logic of Science.

Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling in the financial field.

Policy uncertainty is a class of economic risk where the future path of government policy is uncertain, raising risk premia and leading businesses and individuals to delay spending and investment until this uncertainty has been resolved. Policy uncertainty may refer to uncertainty about monetary or fiscal policy, the tax or regulatory regime, or uncertainty over electoral outcomes that will influence political leadership.

<i>Antifragile</i> (book) 2012 book by Nassim Nicholas Taleb

Antifragile: Things That Gain From Disorder is a book by Nassim Nicholas Taleb published on November 27, 2012, by Random House in the United States and Penguin in the United Kingdom. This book builds upon ideas from his previous works including Fooled by Randomness (2001), The Black Swan (2007–2010), and The Bed of Procrustes (2010–2016), and is the fourth book in the five-volume philosophical treatise on uncertainty titled Incerto. Some of the ideas are expanded on in Taleb's fifth book Skin in the Game: Hidden Asymmetries in Daily Life (2018).

Skin in the Game: Hidden Asymmetries in Daily Life is a 2018 nonfiction book by Nassim Nicholas Taleb, a former options trader with a background in the mathematics of probability and statistics.

References

  1. 1 2 Knight, F. H. (1921) Risk, Uncertainty, and Profit. Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Company
  2. ↑ Köhn, Julia (2017). Uncertainty in economics: a new approach. Cham: Springer. ISBN   978-3-319-55351-1.
  3. ↑ Shackle, G.L.S. (1968). "Expectations, Investment and Income" . Oxford: Clarendon Press. ISBN   0-19-828157-9.
  4. ↑ Economics as an Art of Thought: Essays in Memory of G.L.S. Shackle. Place of publication not identified: Routledge. 2013. ISBN   978-0-415-86230-1.
  5. ↑ Taleb, Nassim Nicholas (2015). Silent Risk (PDF).
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.