KNIGHT ON THE ROLE OF UNCERTAINTY
Knight identifies the entrepreneur as a recipient of pure profit. Profit is the residual income available after all contractual payments have been deducted from the revenues of the enterprise. It is the reward to the entrepreneur for bearing the costs of uncertainty.
Knight identifies uncertainty with a situation where the probabilities of alternative outcomes cannot be determined either by a priori reasoning or by statistical interference. A priori reasoning is simply irrelevant to economic situations. Statistical interference is impossible because the situation involves a unique event. It does not belong to a larger population of identical events. In particular there is no precedent for it, so that no assessment of probability can be made on the basis of relative frequency. This is the foundation for Knight’s distinction between uncertainty and risk.
Uncertainty is a ubiquitous aspect of business decisions because production takes time. Decisions on inputs must be made now in order to create output for the future. Households as factor owners demand spot payment for their services. At the same time they are unwilling to commit themselves on future demand for the product because they anticipate that unforeseeable changes will occur.
But the consumer does not even contract for his goods in advance, generally speaking. A part of the reason might be the consumer’s uncertainty as to his ability to pay the end of the period, but this does not seem to be important in fact. The main reason is that he does not know what he will want, and how much, and how badly. Consequently, he leaves it to producers to create goods and hold them ready for his decision when the time comes. The clue to the apparent paradox is of course in the law of large numbers. The consolidation of risks (or uncertainties). The consumer is to himself only one to the producer he is a mere multitude in which individuality is lost. It turns out that an outsider can foresee the wants of am multitude with more ease and accuracy than an individual can attain with respect to his own. This phenomenon gives us the most fundamental feature of the economic system, production for a market.
Knight is mainly concerned to show how markets, together with institutions such as the large corporation, contribute to specializing uncertainty-bearing in the hands of those best equipped to make decisions under uncertainty. The main quality required for making production decisions is foresight they have, and competition ensures that individuals with the greatest degree of foresight (relative to other abilities) specialize in making production decisions.
However, it does not follow that individuals with foresight will become selfemployed and make decisions on their own behalf. They may instead become managers of a large firm. Knight argues that business uncertainty can be reduced through ‘consolidation’. Consolidation is to uncertainty what insurance is to risk: It is a method of reducing total uncertainty by pooling individual instances and allowing each individual to hold a share of the pool. It is widely recognized today that an individual’s exposure to uncertainty can be reduced through portfolio diversification in the equity market. Knight recognizes this possibility which he calls ‘diffusion’ but he does not accord it much prominence as a vehicle for the reduction of uncertainty. He believes that uncertainty is reduced mainly through the pooling of uncertainties by the large firm.
The gains in uncertainty- reduction from large scale organization are, in Knight’s view, quite considerable. So much so, that the most important uncertainties relate not to producing for a market itself, but to the selection of suitable mangers to take production decisions. Once the firm has recruited a person with foresight much of the uncertainty in producing of a market is eliminated. The crucial decisions made within the large firm are decisions about personal recruitment. The pure profit generated by a firm is compensation to people for bearing uncertainty that they have delegated decisions to the wrong sort of person.
Knight does not seem to anticipate that there will be much difficulty in ensuring that managers with foresight exercise it properly on the stockholders behalf. The moral hazard problem is negligible. Presumably, because close supervision of the manager is possible. Much greater moral hazard arises with the directors of the firm who recruit the managers and supervise them on the stock holder’s behalf. The unavoidable moral hazard involved in delegating direction means that directors cannot possibly be fully insured against the consequences of their decisions. They must operate under profit related incentives and so effectively they must become stock holders in the firm. Thus, directors who make decisions under uncertainty also bear the consequences of those decisions and are ipso facto recipients of pure profit.
Some people have good judgment of other people’s abilities and others do not. But no one can be certain of his or her own judgment of other people’s abilities. As a result, confidence in his own judgment is perhaps the most important characteristic of the entrepreneur. This has to be coupled with a low version to risk, as reflected in a disposition to back up his judgment with his own capital. The elasticity of supply of self- confident people is, in Knight’s view, the single- most important determinant of the level of profit and of the number of entrepreneurs.
The income of nay particular entrepreneur will, in general, tend to be larger
(i) as he himself as ability and good luck but (ii) perhaps more important , as there is in the society a scarcity itself- confidence combined with the power to make effective guarantees to employees. The abundance or scarcity of mere ability to mange business successfully exerts relatively little influence on profit. The main thing is the rashness or timidity of entrepreneurs (actual and potential) as a class in bidding up the prices of productive services. Entrepreneur’s income, being residual, is determined by the demand for these other services, where demand is a matter of the self- confidence of entrepreneurs as a class, rather than upon a demand for entrepreneur services in a direct sense. We must see at once that it is perfectly possible for entrepreneurs as a class to sustain a net loss, which would merely have to be made up out of their earnings in some other capacity. This would be the natural result in a population combining low ability with high courage. On the other hand, if men generally judge their own abilities well, the general rate of profit will probably be low, whether ability itself is low or high, but much more variable and fluctuating for a low level of real capacity. The condition for large profit is a narrowly limited supply of high- grade ability with a low level of initiative as well as ability.
(ii)
(iii) Knight’s analysis exhibits very clearly the difficulties in theorizing about entrepreneurship, and in particular the problems of structuring the analysis in a coherent way. As a result, Knight’s views have been widely misinterpreted in the past. Many parts of the present work are simply a reformulation of ideas first presented by Knight. The concepts of probability and judgment are slightly different but the basic view of the way that market system allocates judgmental decision- making to entrepreneurs is the same both in cases.
