Judgment, Luck, and Schultz

21 October 2008 at 11:50 am 2 comments

| Peter Klein |

Lasse raised an interesting point a while back about the Knightian concept of judgment, and how it differs from pure luck. Here’s a passage from T. W. Schultz that asks the same question:

[I]t is not sufficient to treat entrepreneurs solely as economic agents who only collect windfalls and bear losses that are unanticipated. If this is all they do, the much vaunted free enterprise system merely distributes in some unspecified manner the windfalls and losses that come as surprises. If entrepreneurship has some economic value it must perform a useful function which is constrained by scarcity, which implies that there is a supply and a demand for their services.

The key to understanding this passage is to recognize Schultz’s rejection, following Friedman and Savage (1948), of the concept of Knightian uncertainty. If all uncertainty can be parametrized in terms of (subjective) probabilities, then decision-making in the absence of such probabilities must be random. Any valuable kind of decision-making must be modelable, must have a marginal revenue product, and must be determined by supply and demand. For Knight, however, decision-making in the absence of a formal decision rule or model — what Knight calls judgment — isn’t random, it’s simply not modelable. It doesn’t have a supply curve, because it is a residual or controlling factor that is inextricably linked with resource ownership. It is a kind of understanding, or Verstehen, that defies formal explanation but is rare and valuable.

Without the concept of Knightian uncertainty, then, Knight’s concept of entrepreneurial judgment makes little sense.

Entry filed under: - Klein -, Entrepreneurship, Theory of the Firm. Tags: .

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2 Comments Add your own

  • 1. spostrel  |  21 October 2008 at 6:29 pm

    This reminds me of an old Robert Klein joke.

    Somene comes on TV with a revolutionary new weight loss plan: “Not a diet, not a pill, not an exercise plan.”

    Klein, eyes bugging out in exasperated curiousity:”WHAT IS IT?”

    Knightian uncertainty is that revolutionary weight loss plan.

  • 2. Rafe  |  21 October 2008 at 8:55 pm

    The kind of creativity that can occur this situation is explored by Buchanan and Vanberg “The Market as a Creative Process” http://books.google.com/books?hl=en&lr=&id=a3BSlCVfTa4C&oi=fnd&pg=PA315&dq=%22V.+Vanberg%22&ots=hJl6D7aI3M&sig=eOYBHKKWJsGNiOOqNXERS1vrDJY

    They demonstrated some of the practical implications of a change in metaphysics by drawing out the implications of the work on the thermodynamics of open and non-linear systems by Ilya Prigogine and the open or indeterminate universe by Karl Popper.

    “Our purpose here is to relate the new orientation in the natural sciences [indeterminism] to a particular nonorthodox strand of thought within economics. [This] involves a shift of perspective from the determinism of conventional physics (which presumably inspired the neoclassical research program in economics) to the nonteleological open-endedness, creative and nondetermined nature of evolutionary processes.”

    The practical concern in the background was the failure of central planning and they consisdered three views of economic events.

    1. Allocation of resources.
    2. Discovery of opportunities to make a profit.
    3. Creation of opportunities.

    “We have suggested that a perceptual vision of the market as a creative process offers more insight and understanding than the alternative visions that elicit interpretations of the market as a discovery process, or, more familiarly, as an allocative process.” The most basic critique of the system pinpointed the defective allocation of resources as a consequence of the incentive structure which did not reward good decisions (or punish bad ones). Kirzner followed Hayek to add another element to the critique because even if the incentive problems were solved there would still be the problem of dispersed knowldedge and the need for entrepreneurs to see better ways to do business. Then Buchanan and Vanberg advanced the crtique another notch. “We suggest that the critique, even as extended, falls short of capturing an essential element in any comparative assessment of the market and the planning alternatives. The teleological feature remains to be exorcised.”

    The teleological element is the idea that the system as a whole has a specific destination or end point in view, a position which depends on the assumption of determinism. That is their critique of equilibrium approaches in general, these all make the illicit assumption of deterministic end points unless equilibrium models are clearly recognised as analytical devices like the frictionless pulleys and weightless strings of the physicist. The key to the creative process is the idea that something can come from nothing which is an important corollary of indeterminism in physics and the world at large.

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