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Knight on Risk and Uncertainty Author(s): Stephen F. LeRoy and Larry D. Singell, Jr. Source: The Journal of Political Economy, Vol. 95, No. 2 (Apr., 1987), pp. 394-406 Published by: The University of Chicago Press Stable URL: http://www.jstor.org/stable/1832078 . Accessed: 21/03/2011 16:38
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Knight on Risk andUncertainty

Stephen F. LeRoy
Universityof California, Berkeley,and Universityof California, Santa Barbara

LarryD. Singell, Jr.
Universityof California, Santa Barbara

It is argued that the received interpretation of Knight's classic riskuncertainty distinction-as concerning whether or not agents have subjective probabilities-constitutes a misreading of Knight. On the contrary, Knightshared the modern view that agents can be assumed always to act as if they have subjective probabilities. We document our contention that by uncertainty Knight instead meant situations in which insurance markets collapse because of moral hazard or adverse selection. Knight's discussion of market failure, although always informal and in places inaccurate, was in many respects a remarkable anticipationof the modern literature.

ARJo KLAMER:Other people say that there are periods with fundamental uncertainty. They refer to the Keynesian concept of uncertainty. ...
ROBERT E. LUCAS, JR.: It's Knight, not Keynes. [Klamer

1984, p. 44] I. Introduction

The distinction between risk and uncertainty is generally interpreted as having to do with whether or not agents can be assumed to act as ifWe have received helpful comments from H. E. Frech, Christian Gilles, and George Stigler.
[Journal of Political Economy, 1987, vol. 95, no. 2] K 1987 by The University of Chicago. All rights reserved. 0022-3808/87/9502-0005$01.50

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RISK AND UNCERTAINTY

395

they have in mind well-defined probabilities on possible outcomes. If so, the situation is one of risk; if not, it is one ofuncertainty. While the distinction between risk and uncertainty so defined is often encountered in the literature, its role until recently has been reduced to the ceremonial: economists, especially those working in the neoclassical tradition, invoke the distinction only in order to rule out uncertainty (see, e.g., Hirshleifer 1970, p. 215). There are good reasons for doing so. In the modern theoryof choice, subjective probabilities are derived from agents' orderings over lotteries. Hence (simplifying) it follows that to deny the existence of subjective probabilities is to deny that agents are able to choose consistently among lotteries. Most economists are unwilling to do without the assumption of consistent choice. Friedman's statement is typical: In his seminal work, Frank Knight drew...