Risk and uncertainty

This article discusses the meaning of uncertainty. We turn to economics for a definition of uncertainty. We also touch upon the implications of the existence of uncertainty for the nature of the future.

Risk and Uncertainty

The concept of (fundamental) uncertainty was introduced in economics by Keynes (1921, 1936 and 1937) and Knight (1921). They felt a distinction should be made between risk and uncertainty.

In case of risk all possible future events or consequences of an action or decision are known. However, the events that will actually materialise are unknown beforehand. In case of risk the probability calculus is applicable and provides a sound basis for risk management, cost/benefit analysis, budget planning, etc.

Both Keynes and Knight argued that often in human decisions not all possible outcomes of an action or decision can be known. These are cases of (fundamental) uncertainty. There are things people simply do not know in advance. In situations of uncertainty the probability calculus has no sound foundation. There is no objective basis for risk management, cost/benefit analysis and other control techniques.

Knight stresses that risk provides a basis for insurance. Uncertainty cannot be insured against. Knight argued that entrepreneurs who dare to act in the presence of the unknown future, emerged as a major response to fundamental uncertainty. Profits are their reward. Without uncertainty no profits would exist.

In Keynes’ view uncertainty gave money, liquidity and finance in general a central role in the economy. The existence of uncertainty of the future is the root cause for economies not automatically tending to full employment. If people are not confident about their own expectations they do not want to commit themselves to irreversible investments. They would like to remain liquid instead. Money in a way is a hedge against uncertainty. It allows its holder to respond quickly and flexibly to any ,at present unknown, future event when it occurs.

By holding money you do not commit yourself. But the supply of money can be increased without almost using any labour. A higher demand for money at the expense of demand for goods and services creates unemployment. If confidence is low, an economy can be locked into below full employment.

Uncertainty is inescapable

The existence of uncertainty is an inescapable element of human existence. People cannot know now what they will discover in the future. Yet future discoveries may co-determine the pay-off/consequences of today’s decisions and shape future events relevant to today’s decisions. There is only one certainty that people have with respect to the future. That is that they may be surprised. Uncertainty is an inherent property of the future. It cannot be reduced.

The existence of uncertainty leads to the role of confidence in people’s own calculations, expectations, et cetera, in making their decisions. Confidence can fluctuate and thereby impact our decisions and their consequences. Confidence is subjective. It cannot be grounded in knowledge about the future, only about that of the past and present.

The nature of the future

The future of society cannot be seen by mankind as being predetermined and as objectively waiting to be discovered. The future cannot be predicted, but people can imagine the future and form subjective expectations about the future (cf. Shackle 1972). They act and interact on the basis of these imaginations and expectations.

The future emerges from these (inter)actions. That may create surprises, positive and negative ones alike, to (some) people. People will respond and adapt to what the future shows to be when it becomes present (see also Arthur 2013). Again in the face of uncertainty of the further future. This is a continuous process without knowable end point or equilibrium.

This continuous process is characterised by both bottom-up and top-down causality. The actions and interactions of individuals together determine the future and the emerged future is one of the determinants of next actions and interactions by individuals.

References

Arthur, W.B. (2013), Complexity Economics: A Different Framework for Economic Thought, Institute for New Economic Thinking (INET), Research Note Nr. 33, March

Keynes, J.M. (1921), A Treatise on Probability, The Collected Writings of John Maynard Keynes, Vol. VIII, London

Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, The Collected Writings of John Maynard Keynes, Vol. VII, London, Chapter 12 in particular

Keynes, J.M. (1937), “The General Theory of Employment”, reprinted in The Collected Writings of John Maynard Keynes, Vol. XIV, pp. 109-124

Knight, F.H. (1921), Risk, Uncertainty and Profit, Boston

Shackle, G.L.S. (1972), Epistemics and Economics. A Critique of Economic Doctrines, Cambridge

Share this article:

This article is from the free online course:

Decision Making in a Complex and Uncertain World

University of Groningen

Get a taste of this course

Find out what this course is like by previewing some of the course steps before you join: