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Entrepreneurship is NOT Risk-bearing

Friday 04 December 2020

Most of the literature I read in economics, management, and entrepreneurship remains sloppy in distinguishing between risk and uncertainty. As we approach the centennial of the publication of Frank H. Knight’s Risk, Uncertainty, and Profit, it is time to revisit his essential thesis: (1) static, deterministic economic models of the firm provide no causal explanation for the existence of profit; (2) where risk can be characterized by a priori or statistical probability distributions, this reduces to the deterministic account and profits will not exist; and (3) profits arise from uncertainty, which is a knowledge problem that can be inherent in the external state of nature or in the boundedness of the economic agent.

Here is the essence of Knight’s argument for uncertainty-bearing as entrepreneurship:

“At the bottom of the uncertainty problem in economics is the forward-looking character of the economic process itself. Goods are produced to satisfy wants; the production of goods requires time, and two elements of uncertainty are introduced, corresponding to two different kinds of foresight which must be exercised. First, the end of productive operations must be estimated from the beginning. It is notoriously impossible to tell accurately when entering upon productive activity what will be its results in physical terms, what (a) quantities and (b) qualities of goods will result from the expenditure of given resources. Second, the wants which the goods are to satisfy are also, of course, in the future to the same extent, and their prediction involves uncertainty in the same way. The producer, then, must estimate (1) the future demand which he is striving to satisfy and (2) the future results of his operations in attempting to satisfy that demand.” (Knight, 1921, section III.VIII.8).

Interestingly, Carl Menger says much the same thing in his 1871 Grundsätze der Volkswirtschaftslehre (Principles of Economics), half a century prior to Knight.

“[t]he greater or less degree of certainty in predicting the quality and quantity of a product that men will have at their disposal due to their possession of the goods of higher order required for its production, depends upon the greater or less degree of completeness of their knowledge of the elements of the causal process of production, and upon the greater or less degree of control they can exercise over these elements. The degree of uncertainty in predicting both the quantity and quality of a product is determined by opposite relationships. Human uncertainty about the quantity and quality of the product (corresponding goods of first order) of the whole causal process is greater the larger the number of elements involved in any way in the production of consumption goods which we either do not understand or over which, even understanding them, we have no control—that is, the larger the number of elements that do not have goods-character.” (Menger, 1871, Ch.1, Sec. 4, Zeit—Irrthum [Time and Error]; translated by Dingwall and Hoselitz, 2007)

Menger also has a passage that explicitly dismisses risk.

“… it will be evident that I cannot agree with Mangoldt, who designates “risk bearing” as the essential function of entrepreneurship in a production process, since this “risk” is only incidental and the chance of loss is counterbalanced by the chance of profit.” (Menger trans 2007, p. 161).           

Menger footnotes this disagreement based upon Mangoldt (1855). In the original, one finds “die “Gefahr”doch nur etwas accidentielles ist” (Menger 1871, footnote to page 138). The risk is accidental, not incidental. Thus, it appears that Menger denies risk-bearing, in the sense of aleatory probabilities of economic outcomes, as an entrepreneurial function.

More on this in coming posts.

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