Risk and Uncertainty
In Human Action, Mises argues that in a free market economy, making a profit depends on the judgment, or appraisement, that entrepreneurs make of particular situations. He says:
Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. If everybody is correct in anticipating the future state of the market of a certain commodity, its price and the prices of the complementary factors of production concerned would already today be adjusted to this future state. Neither profit nor loss can emerge for those embarking upon this line of business.
The specific entrepreneurial function consists in determining the employment of the factors of production. The entrepreneur is the man who dedicates them to special purposes. In doing so he is driven solely by the selfish interest in making profits and in acquiring wealth. But he cannot evade the law of the market. He can succeed only by best serving the consumers. His profit depends on the approval of his conduct by the consumers.
Mises’s argument depends on a distinction introduced by Frank Knight in his book Risk, Uncertainty, and Profit (1921). In a situation of risk, the actor knows the possible outcomes and can apply the probability calculus to them. In a situation of uncertainty, he cannot so, either because he cannot use the probability calculus or because he does not know all the possible outcomes. He must rely on his judgment about the particular case.
Mises uses this distinction and cites Knight’s book.
With regard to contingencies the expected incidence of which is too rare and too irregular to be dealt with in this way [by reserve funds] by individual firms of normal size, concerted action on the part of sufficiently large groups of firms take care of the matter. The individual firms cooperate under the principle of insurance against damage caused by fire, flood, or other similar contingencies. Then an insurance premium is substituted for an appropriation to a contingency reserve. At any rate, the risks incurred by accidents do not introduce uncertainty into the conduct of the technological processes.
Mainstream neoclassical economists do not accept this distinction. Milton Friedman says,
in his seminal work, Frank Knight drew a sharp distinction between risk, as referring to events subject to a known or knowable probability distribution, and uncertainty, as referring to events for which it was not possible to specify numerical probabilities. I’ve not referred to this distinction because I do not believe it is valid….We may treat people as if they assigned numerical probabilities to every conceivable event.
If Friedman is correct, a key tenet of Austrian economics is wrong; entrepreneurial appraisement must exit the scene.
You won’t be surprised to learn that Mises disagrees with this. It’s meaningless to apply probability calculus to single events.
On the eve of the 1944 presidential election people could have said:…(c) I estimate Roosevelt's chances as 9 to 1….This is a proposition about the expected outcome couched in arithmetical terms. It certainly does not mean that out of ten cases of the same type nine are favorable for Roosevelt and one unfavorable. It cannot have any reference to class probability. But what else can it mean? It is a metaphorical expression….For the comparison is based on a conception which is in itself faulty in the very frame of the calculus of probability, namely the gambler's fallacy. In asserting that Roosevelt's chances are 9:1, the idea is that Roosevelt is in regard to the impending election in the position of a man who owns 90 per cent of all tickets of a lottery in regard to the first prize. It is implied that this ratio 9:1 tells us something substantial about the outcome of the unique case in which we are interested. There is no need to repeat that this is a mistaken idea.
Knight has an amusing comment on this issue. He says,
The saying often quoted from Lord Kelvin…that where you cannot measure, your knowledge is meagre and unsatisfactory; as applied in mental and social science is misleading and pernicious….the Kelvin dictum very largely mean in practice, if you cannot measure, measure anyhow!
Could someone who rejects the distinction between risk and uncertainty still accept what Mises says about how the entrepreneur appraises profit-making opportunities? A supporter of what is called “subjective Bayesianism” might claim that some people, the successful entrepreneurs, are just better than others at assessing the odds in risky situations, and that these people operate intuitively rather than relying entirely on formulas. If Mises is right, though, this makes no sense. I think he’s correct, but I’ll leave it to readers to judge for themselves.