Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, Knightian uncertainty
is risk that is immeasurable, not possible to calculate.
Knightian uncertainty is named after University of Chicago
The University of Chicago is a private research university in Chicago, Illinois, USA. It was founded by the American Baptist Education Society with a donation from oil magnate and philanthropist John D. Rockefeller and incorporated in 1890...
economist Frank Knight
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. Nobel laureates James M. Buchanan, Milton Friedman and George Stigler were all students of Knight at Chicago. Knight supervised...
(1885–1972), who distinguished risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...
in his work Risk, Uncertainty, and Profit:
- "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."
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
The word probability has been used in a variety of ways since it was first coined in relation to games of chance. Does probability measure the real, physical tendency of something to occur, or is it just a measure of how strongly one believes it will occur? In answering such questions, we...
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
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...
The Ellsberg paradox
The Ellsberg paradox is a paradox in decision theory and experimental economics in which people's choices violate the expected utility hypothesis.An alternate viewpoint is that expected utility theory does not properly describe actual human choices...
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
In decision theory and economics, ambiguity aversion describes an attitude of preference for known risks over unknown risks. People would rather choose an option with fewer unknown elements than with many unknown elements. It is demonstrated in the Ellsberg paradox In decision theory and...
Nassim Nicholas Taleb has developed the Black swan theory
The black swan theory or theory of black swan events is a metaphor that encapsulates the concept that The event is a surprise and has a major impact...
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.