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ERM Glossary: Knightian uncertainty

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The intrinsic nature of Knightian uncertainty is that it is immeasurable, i.e. not possible to estimate reliably. It is named after the University of Chicago economist Frank Knight (1885-1972). Knight (1921) highlighted the intrinsic difference between this type of ‘uncertainty’ and ‘risk’ (the latter being amenable to quantitative analysis):

 

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.

 

According to Cagliarini and Heath (2000), Knight’s interest in the difference between ‘uncertainty’ and ‘risk’ was spurred by the desire to explain the role of entrepreneurship and profit in the economic process. Knight viewed profits accruing to entrepreneurs as being justified and explained by their willingness to bear the consequences of the uncertainties inherent in production process that cannot be readily quantified. Where the risks can be quantified then it is generally possible (at least in theory) to hedge them or diversify them away, i.e. they are not really ‘risks’ at all, or at least not ones that should obviously bear any excess profits.

 

Despite it not being possible to measure ‘uncertainty’, it is still arguably possible to infer some characteristics about it, in particular how others might react to it, see e.g. Kemp (2010).

 


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