Knightian uncertainty

In economics, Knightian uncertainty is risk that is immeasurable, not possible to calculate.

Knightian uncertainty is named after University of Chicago economist Frank Knight (1885–1972), who distinguished risk and uncertainty in his work Risk, Uncertainty, and Profit:

The difference between predictable variation and unpredictable variation is one of the fundamental issues in the philosophy of probability, and different probability interpretations treat predictable and unpredictable variation differently. The distinction and debate has a long history, referred to as and discussed at common-cause and special-cause.

The Ellsberg paradox is based on the difference between these two types of risk, and the problems it poses for utility theory – one is faced with an urn that contains 30 red balls and 60 balls that are either all yellow or all black, and one then draws a ball from the urn. This poses both uncertainty – whether the non-red balls are all yellow or all black – and probability – whether the ball is red or non-red, which is ⅓ vs. ⅔. Expressed preferences in choices faced with this situation reveal that people do not treat these risks the same. This is also termed "ambiguity aversion".

The term Black swan event, coined by Nassim Nicholas Taleb, refers to an important and inherently unpredictable event that, once occurred, is rationalized with the benefit of hindsight. Historical developments like the widespread adoption of the personal computer, were entirely impossible to predict but nevertheless had world-changing effects. Another position of the black swan theory is that appropriate preparation for these events is frequently hindered by the pretense of knowledge of all the risks; in other words, Knightian uncertainty is presumed to not exist in day-to-day affairs, often with disastrous consequences.

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