The Economics Book

163

Traders in a futures market in São

Paulo, Brazil, are effectively betting on

the future movements of commodity

prices. Even a small price change can

result in enormous profits or losses.

See also: Economic man 52–53 ■ Irrational decision making 194–95 ■ Paradoxes in decision making 248–49 ■
Financial engineering 262–65 ■ Behavioral economics 266–69

WAR AND DEPRESSIONS

analyzed the probabilities in
gambling games. In the 1920s US
economist Frank Knight became
one of the first economists to
analyze the relationship between
risk and profit in a free market
economy. He also made a distinction
between risk and uncertainty. Risk,
by his definition, occurs when the
outcome of a course of action is not
known, but where it is possible to
determine the probability of various
possible outcomes. This allows a
mathematical assessment of the
level of risk, which can then be
insured against. Also, the expected
utility can then be compared
realistically with alternatives.
For Knight “uncertainty”
describes a situation where the
probability of outcomes is not
known so the various possible
outcomes cannot be compared in
terms of expected utility. This
means that the risk cannot be
measured mathematically. Knight
argues that when firms are prepared
to accept this uninsurable
uncertainty, and their risk-taking
pays off, it produces profits—even
when the economy is in a state of
long-term equilibrium.

Investors and entrepreneurs often

operate under conditions of risk

and uncertainty, recognizing

the potential for high returns. On

occasions this “who dares, wins”

attitude can become extreme, as

in the cases of bond traders and

bankers who have made headlines

for losing or gaining vast fortunes.

Most people, such as ordinary

savers who place their life savings

in a fixed-interest saving account,

prefer to play it safe, forgoing profits

in return for a risk-free investment.

There is essentially a spectrum of

risk preferences, ranging from the

risk-loving to the risk-averse, just as

there is a range of levels of risk. The

attraction of a higher return can

begin to tempt even the risk-averse

to take on some level of risk.

Levels of risk

Risk applies to all kinds of economic

activities, including investing

money in stocks and shares,

making unsecured rather than

secured loans, and selling goods

in a completely new market. Our

personal economic decisions are

also framed in terms of risk:

whether we work for an employer

or start up our own business, and

how we invest our personal

savings. Insurance markets exist

because we are risk averse.

Insurers and actuaries, credit-

rating agencies, and market

research can help us assess the

level of risk and whether the

returns make it worth taking, but

some unfathomable degree of

uncertainty will always remain. ■

Profit arises out of the

inherent, absolute

unpredictability of things.

Frank Knight

Frank Knight

One of the foremost economists

of his generation, Frank Knight

was born in Illinois in 1885. He

studied philosophy at Cornell,

switching to economics after a

year. His PhD dissertation

formed the basis of his best-

known work, Risk, Uncertainty

and Profit.

Knight was the first Professor

of Economics at the University of

Iowa, and then moved to Chicago

University in 1927, where he

remained for the rest of his life.

He was an early member of the

Chicago School of economists.

His students included future

Nobel prize winners Milton

Friedman, James Buchanan, and

George Stigler, who described

Knight as having “unceasing

intellectual curiosity.”

Key works

1921 Risk, Uncertainty and Profit

1935 The Ethics of Competition

1947 Freedom and Reform:

Essays in Economics and Social

Philosophy