Risk, Uncertainty, and Profit
By Frank H. Knight
The text has been altered as little as possible from the original edition (
Risk, Uncertainty, and Profit, Frank H. Knight, Ph.D., Associate Professor of Economics in the State University of Iowa; Boston and New York, Houghton Mifflin Co., The Riverside Press, 1921).A few corrections of obvious typos were made for this website edition. However, because the original edition was so internally consistent and carefully proofread, we have erred on the side of caution, allowing some typos (such as for proper nouns and within references) to remain lest someone doing academic research wishes to follow up. We have changed small caps to full caps for ease of using search engines.Lauren Landsburg
Editor, Library of Economics and Liberty
2000
First Pub. Date
1921
Publisher
Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Co.
Pub. Date
1921
Comments
1st edition. Based on award-winning dissertation essay.
Copyright
The text of this edition is in the public domain. Picture of Frank H. Knight courtesy of Ethel V. Knight.
Author’s Preface
There is little that is fundamentally new in this book. It represents an attempt to state the essential principles of the conventional economic doctrine more accurately, and to show their implications more clearly, than has previously been done. That is, its object is refinement, not reconstruction; it is a study in “pure theory.” The motive back of its presentation is twofold. In the first place, the writer cherishes, in the face of the pragmatic, philistine tendencies of the present age, especially characteristic of the thought of our own country, the hope that careful, rigorous thinking in the field of social problems does after all have some significance for human weal and woe. In the second place, he has a feeling that the “practicalism” of the times is a passing phase, even to some extent a pose; that there is a strong undercurrent of discontent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach a clearer understanding of the meaning of terms and dogmas which pass current as representing ideas. For the first of these assumptions a few words of elaboration or defense may be in place, in anticipation of the essay itself.
The “practical” justification for the study of general economics is a belief in the possibility of improving the quality of human life through changes in the form of organization of want-satisfying activity. More specifically, most projects of social betterment involve the substitution of some more consciously social or political form of control for private property and individual freedom of contract. The assumption underlying such studies as the present is that changes of this character will offer greater prospect of producing real improvement if they are carried out in the light of a clear understanding of the nature and tendencies of the system which it is proposed to modify or displace. The essay, therefore, endeavors to isolate and define the essential characteristics of free enterprise as a system or method of securing and directing coöoperative effort in a social group. As a necessary condition of success in this endeavor it is assumed that the description and explanation of phenomena must be radically separated from all questions of defense or criticism of the system under examination. By means of first showing what the system is, it is hoped that advance may be made toward discovering what such a system can, and what it cannot, accomplish. A closely related aim is that of formulating the
data of the problem of economic organization, the unchangeable materials with which, and conditions under which, any machinery of organization has to work. A sharp and clear conception of these fundamentals is viewed as a necessary foundation for answering the question as to what is reasonably to be expected of a method of organization, and hence of whether the system as such is to be blamed for the failure to achieve ideal results, of where if at all it is at fault, and the sort of change or substitution which offers sufficient chance for improvement to justify experimentation.
The net result of the inquiry is by no means a defense of the existing order. On the contrary, it is probably to emphasize the inherent defects of free enterprise. But it must be admitted that careful analysis also emphasizes the fundamental difficulties of the problem and the fatuousness of over-sanguine expectations from mere changes in social machinery. Only this foundation-laying is within the scope of this study, or included within the province of economic theory. The final verdict on questions of social policy depends upon a similar study of other possible systems of organization and a comparison of these with free enterprise in relation to the tasks to be accomplished. This one “conclusion” may be hazarded, that no one mode of organization is adequate or tolerable for all purposes in all fields. In the ultimate society, no doubt, every conceivable type of organization machinery will find its place, and the problem takes the form of defining the tasks and spheres of social endeavor for which each type is best adapted.
The particular technical contribution to the theory of free enterprise which this essay purports to make is a fuller and more careful examination of the rôle of the
entrepreneur or enterpriser, the recognized “central figure” of the system, and of the forces which fix the remuneration of his special function. The problem of profit was suggested to the writer as a suitable topic for a doctoral dissertation in the spring of 1914 by Dr. Alvin Johnson, then Professor of Economics in Cornell University. The study was chiefly worked out under the direction of Professor Allyn A. Young after Dr. Johnson left Cornell. My debt to these two teachers I can only gratefully acknowledge. Since the acceptance of the essay as a thesis at Cornell in June, 1916, and its submission in the Hart, Schaffner & Marx competition in 1917, it has been entirely rewritten under the editorial supervision of Professor J. M. Clark, of the University of Chicago. I have also profited much by discussions with Professor C. O. Hardy, my colleague at the same institution, and by access to his unpublished “Readings on Risk and Risk-Bearing.” Professor Jacob Viner, of the University of Chicago, has kindly read the proof of the entire work. My obligations to various economists through their published work are very inadequately shown by text and footnote references, but are too comprehensive and indefinite to express in detail.
Iowa City, Iowa
January, 1921
Introduction to Social Philosophy, p. 58. Also Bagehot,
Economic Studies, no. 1: “The Presuppositions of English Political Economy.”
chapter VII). We shall see that there is ultimately no such fact as deduction as commonly understood, that inference is from particulars to particular, and that generalization is always tentative and a mere labor-saving device. The fact is, however, that we can study facts intelligently and fruitfully only in the light of hypotheses, while hypotheses have value more or less in proportion to the amount of antecedent concrete knowledge of fact on which they are based. The actual procedure of science thus consists of making and testing hypotheses. The first hypotheses in any field are usually the impressions of “common sense”; i.e., of that superficial knowledge forced upon intelligence by direct contact with the world. Study, in the light of any hypothesis, corrects or refutes the guiding generalization and suggests new points of view, to be criticized and tested in the same way, and so the organization of the material proceeds. The importance of generalization arises from the fact that as our minds are built, it is nearly fruitless to attempt to observe phenomena unless we approach them with questions to be answered. This is what a hypothesis really is, a question. Superficial observation suggests questions which study answers. If and so long as it answers a question affirmatively and the answer is not contradicted by the test of practical application or casual observation, we have a law of nature, a truth about our environment which enables us to react intelligently to it in our conduct.
There is, then, little if any use for induction in the Baconian sense of an exhaustive collection and collation of facts, though in some cases this may be necessary and fruitful. On the other hand, there is equally little use for deduction taken as doing more than suggesting hypotheses, subject to verification. It is to be noted, however, that our common-sense generalizations have a very high degree of certainty in some fields, giving us, in regard to the external world, for instance, the “axioms” of mathematics. Even more important in the present connection is the rôle of common sense or intuition in the study of human phenomena. Observation and intuition are, indeed, hardly distinguishable operations in much of the field of human behavior. Our knowledge of ourselves is based on introspective observation, but is so direct that it may be called intuitive. Its extension to our fellow human beings is also based upon the interpretation of the communicative signs of speech, gesture, facial expression, etc., far more than upon direct observation of behavior, and this process of interpretation is highly instinctive and subconscious in character. Many of the fundamental laws of economics are therefore properly “intuitive” to begin with, though of course always subject to correction by induction in the ordinary sense of observation and statistical treatment of data.
These brief statements must not be thought of as dealing with philosophical problems. The writer is, like Mill, an empiricist, holding that all general truths or axioms are ultimately inductions from experience. By induction as a method is meant deliberate, scientific induction, the planned study of instances for the purpose of ascertaining their “law.” And deduction means reaching new truth by the application of general laws to particular cases. In the present view both of these processes are regarded as suggestive merely, exhaustive induction and conclusive deduction being alike impossible.
Essays on Unsettled Questions, no. 5, which really leaves little to be said on the subject. Also Cairnes, on the
Character and Logical Method of Political Economy, and the discussions of methodology of the English economists generally. The conception of the “economic man” was one way of emphasizing the abstract and simplified character of the premises of the science. Keynes’s
Scope and Logical Method of Political Economy is as ably clear and conclusive discussion of this whole subject.
Chapter VI.)
Part I, Chapter II.
Die Lehre vom Unternehmergewinn. Leipsic, 1855.
Pierstorff, J.,
Die Lehre vom Unternehmergewinn. Berlin, 1875.
Mataja, V.,
Der Unternehmergewinn. Vienna, 1884.
Gross, G.,
Die Lehre vom Unternehmergewinn. Leipsic, 1884.
Porte, M.,
Entrepreneurs et profits industriels. Paris, 1901.
Theories of Production and Distribution, chap. VI, sec. 2; also the same author’s article on “Profit” in Palgrave’s
Dictionary of Political Economy. In opposition to the German historians and critics, who take the classical economists very literally, Cannan is sure that they really held, like their French followers, a wage theory of profit. Between the two views this seems the fairer on the whole, but it could hardly be maintained that the difference in expression does not represent some difference in thought. However, much of the contrast is undoubtedly due to differences in the use of terms. Old words used to designate new things necessarily become ambiguous, and “profit” is still correctly used with several different meanings.
Dictionnaire de l’économie politique, Paris, 1852. It is true that in another work
(Traité d’économie politique, 2d ed., 1867) Courcelle was not so explicit, and also that in the same article he says that profit depends on the intelligence of the entrepreneur and the favorable or unfavorable conditions under which he works. This hesitation may explain Kleinwächter’s classifying him with the followers of Say and adherents of the wages theory. (See
Das Einkommen and seine Verteilung, p. 278.) It seems more probable, however, that Courcelle glimpsed the fact (which Kleinwächter did not) that the assumption of a “risk” of error in one’s own judgment, inherent in the making of a responsible decision, is a phenomenon of a different character from the assumption of “risk” in the insurance sense. We shall build largely upon this distinction later.
Political Economy, Edinburgh, 1829, pp. 263 and 269, note.
Handwörterbuch der Staatswissenschaften. Dr. Thorstein Veblen’s conceptions of capital and profit show strong leanings toward the same views.
Handbuch der PolitischenÖkonomie, 2d ed. (Tübingen, 1885), pp. 670 ff.
Other works in the same group with the above are:
Dab Unternehmen and der Unternehmergewinn. Vienna, 1884. (The same date of publication as Gross and Mataja.)
A. Wirminghaus,
Das Unternehmergewinn and die Beteiligung der Arbeiter am Unternehmergewinn. Jena, 1886.
E. Zuns,
Swei Fragen des Unternehmer-Einkommens. Berlin, 1881.
A. Körner,
Unternehmen and Unternehmergewinn. Vienna,
1893.
Théorie des marchées économiques (Paris, 1910). In his view profit is the remuneration of the
idée productrice, which is elevated to the position of an independent productive factor. His book outlines an ingenious and suggestive theory of distribution. See review by Professor A. A. Young,
American Economic Review, vol. I, pp. 549 ff.
Quarterly Journal of Economics, vol. I, pp. 265 ff., and vol. II, pp. 263 ff. (Macvane held a monopoly theory; cf.
Quarterly Journal of Economics, vol. II, pp. 1 ff. and 453 ff.) A view similar to that of Walker has been advocated in France by Leroy-Beaulieu (Sr.). See
Mémories de l’Academie des sciences morales et politiques, vol. I, pp. 717 ff, and
Traité d’économie politique, part IV, chap. IX.
Quarterly Journal of Economics, vol. V, pp. 289 ff.
ibid., vol. V, pp. 263 ff.
More exhaustive than either Clark or Hobson is Wicksteed,
The Coördination of the Laws of Distribution, London, 1894.
Distribution of Wealth. Carver’s distinction between compensation for risk-taking and the results of successful risk-taking points to the direction in which a solution of the problem is to be sought. Other writers also have seen the importance of a critical dissection of the risk concept, but none have so far carried out the work. Unquestionably the best of these textbook discussions is that of Professor F. M. Taylor in his unpublished
Principles of Economics, a work characterized throughout by correctly reasoned and accurately stated theoretical argument.
The Distribution of Wealth, 1900; and
Essentials of Economic Theory, 1907.
(Theorie der Wirtschaftliche Entwickelung.)
overcome obstructions and take risks.” (My italics.) It would seem that
effort and
risk have some connection with the income of the “entrepreneur as such,” as well as change and friction. Along the same line is the statement in his first chapter (p. 3) that “free competition tends to give to labor what labor creates, to capitalists what capital creates, and to entrepreneurs what the coördinating function creates.” When we ask, as we presently shall, whether the “effort” and “risk” connected with making progress, or the income to which they give rise, are essentially different from any other effort and risk and their incomes, we shall find ourselves forced to answer in the negative, and to look outside the fact of change altogether for an explanation of the unique income of the entrepreneur.
op. cit., pp. 13-14. (My italics.)
Enterprise and the Productive Process (1907). Articles of earlier date in the
Quarterly Journal of Economics contain briefer statements.
“The final consumer is forced to include in the price he pays for any product not only enough to cover all the items of cost to the entrepreneur,—among which items is a sum sufficient to cover the actuarial or average losses incidental to the various risks of all kinds necessarily assumed by the entrepreneur and his insurers,—but a further sum, without which, as an inducement, the entrepreneur, or enterpriser, and his insurers will not undergo or suffer the irksomeness of being exposed to risk.
“This surplus of consumer’s cost over entrepreneur’s cost, universally regarded as profit, and, from the nature of the case, an unpredetermined residue, is the inducement for the assumption by the entrepreneur, or enterpriser, of all the risks, whatever their nature, necessitated by the process of production. As the inducement to any given action and the reward for that action are the same thing,—the difference being not in the thing itself, but only in the point of time from which it is looked upon,—the unpredetermined residue, which served as the inducement to risk at the commencement of any industrial transaction must necessarily, when determined and realized at its close, be regarded as the result, reward, of the risks undergone.”
(Quarterly Journal of Economics, vol. XV, pp. 603-20.) (In the original the portion quoted is all in italics.)
Quarterly Journal of Economics, vol. XV, p. 86.
Quarterly Journal of Economics, vol. VII, p. 468.
Quarterly Journal of Economics, vol. XV, pp. 456 ff., and
The Distribution of Wealth, chap. VII. Also A. A. Young in Ely’s
Outlines of Economics, 3d ed., chap. XXV. The phrase “successful risk-taking,” used by both Carver and Young, like Hawley’s “risks wisely selected,” is certainly descriptive of the origin of profits. What is wanted is an examination of the meaning of risk-taking which will elucidate the conditions under which it will be successful and show the significant differences between cases of success and cases of failure.
Quarterly Journal of Economics, vol. XV, p. 88.
generally known, known to all to whom they are of any concern.
End of Part I Notes.
Part II, Chapter III.