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".

Black swan events

The term Black swan event, coined by Nassim Nicholas Taleb, refers to an important and inherently unpredictable event that, once occurred, is rationalized with the benefit of hindsight. Historical developments like the widespread adoption of the personal computer, were entirely impossible to predict but nevertheless had world-changing effects. 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.

Time-shifted financial instruments

Time-shifted financial instruments, invented by Marc Groz,^[2] refer to swaps with future cash flows that are at least partially determined by randomly selected returns from one or more defined time periods. Such instruments may be used to estimate the market price of Knightian uncertainty.^[3]

References

1. Knight, F. H. (1921) Risk, Uncertainty, and Profit. Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Company
2. Groz, Marc M. (2013) Method and System for managing time-shifted financial instruments.
3. Groz, Marc M. and Huff, Mike (2016) Three approaches to value, risk, and uncertainty.