A Century of Risk, Uncertainty, and Profit
By Ross Emmett
In 1917, Frank Knight submitted an essay entitled “Cost, Value, and Profit” to Hart, Schaffner, and Marx as part of an essay contest whose aim was “to draw the attention of American youth to the study of economic and commercial subjects.”1 Knight’s essay ended up winning second place. First place went to E. E. Lincoln, for his study of The Results of Municipal Electrical Lighting in Massachusetts, a very good example of institutional economists’ interest in the intersection of industrial studies and public administration which received several nice reviews. Both first and second place manuscripts were entitled by the terms of the essay prize to be published. Lincoln’s book was published immediately after the contest, appearing in 1918. Knight, on the other hand, heavily revised his manuscript at least once more while he taught during 1917-1919 at the University of Chicago and then again between 1919 and 1921 at the University of Iowa. When Risk, Uncertainty and Profit was published in 1921, it received only two reviews. However, while Lincoln’s study was quickly forgotten, Knight’s ended up changing the course of economic theory and teaching in the twentieth century.
How so, you might ask? What can a single book do?
That Lincoln’s essay on municipal lighting won first prize was indicative of a shift in American economics graduate education, which had largely turned away from classic laissez-faire. Senior undergraduate students had previously learned classical laissez-faire economics in courses that assigned John Stuart Mill’s Principles of Political Economy or Francis Wayland’s Elements of Political Economy. The first graduate programs in economics, started in the 1880s, mirrored the German historical school methods that directed students to the study of a particular economic topic—labor, public utilities, transportation, trade, public finance, etc. These programs tended to be light on economic theory (some did not even require theory courses, although they were always offered), while providing historical and institutional study that would prepare students for a career of topical study. Knight’s approach in Risk, Uncertainty and Profit suggested that a core set of economic ideas were necessary to learn in order to understand any economic phenomena, challenging the prevailing institutionalist orthodoxy. Equally important, Knight’s contributions to the theory of perfect competition staked out a position different than those of existing theoretical traditions. While it shared much in common with both the Marshallian and Austrian traditions, Knight also provided a unique explanation for business profit. This explanation reflected modernist tendencies to emphasize uncertainty, while simultaneously grounding the explanation on the willingness of the entrepreneur to make judgments in the midst of uncertainty.
Knight’s Risk, Uncertainty, and Profit also changed how economists thought about competition, largely due to the influence of one of Knight’s own early students. Edward Chamberlin was an undergraduate at the University of Iowa in the early 1920s when he took Knight’s economic theory course. In the introduction to his The Theory of Monopolistic Competition (1934),2 Chamberlin mentions the discussion in Risk, Uncertainty and Profit of all the various prerequisites for perfect competition, suggesting that the inspiration for his own study came from Knight’s comment that, “it is remarkable that the theoretical treatment of economics has related so exclusively to complete monopoly and perfect competition.”3 Ironically, while Chamberlin had taken up the task of filling the gap between these polar extremes, Knight himself had changed his mind about the need for anything other than the theory of perfect competition. As East Coast economists began to follow Chamberlin’s argument, Knight and another of his students, George Stigler, became Chamberlin’s staunchest opponents (see Knight’s 1939 essay “Imperfect Competition”4). Still, Risk, Uncertainty and Profit can be said to have helped launch the monopolistic competition tradition, if indirectly.
The role that Risk, Uncertainty and Profit is best known for today is the contribution it made to the teaching of and theorizing about competitive markets. And here two institutions—the London School of Economics and the University of Chicago—are central to our story. Lionel Robbins began teaching the undergraduate General Principles of Economic Analysis course at the LSE in 1929, and by 1935 had made Knight’s text central to the course. Indeed, Risk, Uncertainty and Profit was so central to Robbins’ LSE teaching that early in 1933, he realized the existing supply was insufficient to match student demand at any price that would fit within a student’s budget constraint! Given that the publisher had ceased further printing of the book, Robbins pleaded with Knight to allow the LSE to include it in the new series of Reprints of Economics Classics. Knight agreed not only to the re-publication but also to writing a new introduction, and the LSE reprint edition soon became the standard, superseded only when George Stigler arranged for another reprint by the University of Chicago Press in 1971.
Risk, Uncertainty and Profit also played a central role in the teaching of price theory at the University of Chicago. When Knight left Iowa to return to Chicago in 1928, Jacob Viner was teaching economic theory there. Knight was, in fact, primarily hired to teach history of economic thought and institutionalism. Viner’s price theory course extended the Marshallian “real cost” tradition, of which Knight was critical, now relying more on the Austrian doctrine of opportunity cost. But Viner was often away on public service, and thus from about 1930 until Viner’s departure for Princeton in 1946, both Knight and Viner taught price theory. Both professors included the theory chapters of Risk, Uncertainty and Profit on their reading lists, but students were quick to spot where both departed from its theoretical contributions. I say both because after 1930, Knight re-thought his way through price theory as he taught it to graduate students, and created new treatments of cost, utility, capital, and interest theory. Chicago’s graduate students, therefore, had a front row seat watching a major theorist in the course of changing his mind. When Knight and Viner were both teaching, graduate students would attend both sets of lectures to see the progress of their debate. Between the early 1930s and the mid-1940s, a new Chicago price theory emerged that assumed the background of Marshall’s Principles and Knight’s Risk, Uncertainty and Profit, but diverged sharply between Viner and Knight. And the tradition continued; Milton Friedman, who replaced Viner, extended the Marshallian tradition in his teaching and research, while George Stigler extended the Knightian tradition. Still, both sides of the Chicago price theory tradition emphasized the importance of being deeply immersed in the theory of perfect competition.
James M. Buchanan, reflecting on his graduate student experience with Chicago price theory as taught by Friedman and Knight, remarked that it converted him from a “soft” socialist to an apostle of laissez-faire in a matter of a few short weeks. The effect was similar on others, and the Chicago tradition grew, but it did not abandon its roots in basic price theory. Between 1930 and 2010—eighty years—five individuals bore primary responsibility for teaching the first price theory course to incoming graduate students in economics: Jacob Viner, Frank Knight, Milton Friedman, Arnold Harberger, and Gary Becker. Two Nobel laureates and two winners of the AEA Francis A. Walker Medal (discontinued after the creation of the economics Nobel). An amazing legacy, built solidly on Marshallian and Knightian roots.
Risk Versus Uncertainty
But what about “Uncertainty,” the other half of the book? The classic interpretation of Knight’s distinction between risk and uncertainty was built on the notion that he linked uncertainty to situations in which we can only form subjective probabilities about events. This distinction was then used to identify an entrepreneur as someone who was willing to bear such uncertainty in particular circumstances. While individuals and firms internalized objective probabilities, entrepreneurs bore the uncertainty associated with subjective probabilities.
Stephen LeRoy and Larry Singell (1987) argued thirty years ago that the classic interpretation of Knight’s distinction may satisfy Austrians who see the economy as constantly out of (and perhaps moving toward) equilibrium, but it does not satisfy Chicago or mainstream theorists.5 Three alternative interpretations thus developed. The first had its roots in Milton Friedman’s (1953) methodological argument for using basic tools until one found it necessary to use something more complicated. Friedman simply assumed that uncertainty could be collapsed into risk analysis unless there was some good reason not to, and he argued that there was almost never a good reason not to.6 The second interpretation emerged from the development of Bayesian statistics, which provided theoretical tools for subjective probability analysis (see Truman Bewley7). But after LeRoy and Singell’s article, the most common means of distinguishing Knightian uncertainty from risk was to refer to Knight’s own suggestion regarding the presence of markets. If one could insure against some unknown outcome, it was risk; if one could not, it was uncertainty. As more and more complicated risk instruments were developed over the years, fewer outcomes could be classified as uncertainty.
But then two events occurred. The first was the 2008 financial crisis, created in part by the very financial risk instruments that economists had been arguing would reduce uncertainty. The second event was the publication of Nassim Taleb’s The Black Swan,8 which resurrected Knightian uncertainty as the “highly improbable.” But Taleb did not suggest that uncertainty could be handled by risk markets. Instead, he made a very Knightian argument: since you cannot protect yourself entirely against uncertainty, you should build robustness into your personal life, your company, your economic theory, and even the institutions of your society, to withstand uncertainty and avoid tragic results. These actions imply costs that may limit other aspects of your business, and even your openness to new opportunity.
Hand-in-hand with robustness as a central message of Knight’s theory of uncertainty has come an emphasis on entrepreneurial judgment. The word “judgment” appears more than once for every two pages in Risk, Uncertainty and Profit, and with good reason. Judging when to take up entrepreneurial actions or not, to hire additional staff as employees or contractors is an art, not a science. Nicolai Foss and Peter Klein have recently launched a Knightian (and Austrian) inspired approach to the firm which focuses on its organization of entrepreneurial judgment.9
For nearly one hundred years, Risk, Uncertainty and Profit has continued to inspire new economic thinking. Initially, its opening chapters on the basic structure of neoclassical economic theory provided the opportunity for theorizing about entrepreneurship that built upon Knight’s theory, even while sometimes criticizing it. For the history of twentieth century economics, it is also important to recognize that the economic theories built in two of the institutions that played important educational roles in the inter-war years—the University of Chicago and the London School of Economics—had Risk, Uncertainty and Profit as their foundation. Even today, in the wake of the shake-up in economic theory that has emerged from the 2008 financial crisis, Knight’s theory of entrepreneurial judgment in the midst of uncertainty is still being taken up for further development.
Great books remain current not because their message is timeless, but because they provide ideas that new generations of scholars and businesses judge to provide value to their intellectual and entrepreneurial objectives. Risk, Uncertainty and Profit has certainly proven to be such a book.
 Edward H. Chamberlin, The Theory of Monopolistic Competition, Harvard University Press, 1933.
 Frank Knight, Risk, Uncertainty and Profit, page 193, footnote 1.
 Frank H. Knight, “Imperfect Competition,” Journal of Marketing, vol. 3(4), 1939, pages 360-66.
 Stephen LeRoy and Larry Singell Jr., “Knight on Risk and Uncertainty,” Journal of Political Economy, volume 95(2), 1987, pages 394-406.
 Milton Friedman, “The Methodology of Positive Economics,” in Essays on Positive Economics, University of Chicago Press, 1953, pages 3-43.
 Truman Bewley, “Knightian Decision Theory, Part 1,” Decisions in Economics and Finance, volume 25, 2002, pages 79-110.
 Nassim Taleb, The Black Swan: The Impact of the Highly Improbable, Random House, 2007.
 Nicolai J. Foss and Peter G. Klein, Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge University Press, 2012.