Frank Knight’s Theory of Profit and Economic Risk
Frank H. Knight’s Employer Risk Theory (1885-1972)
The economist Frank H. Knight published his seminal work, Risk, Uncertainty and Profit, in 1921. This book explains his theory of the entrepreneur.
Key Distinctions in Knight’s Theory
Knight highlights the crucial distinction between:
- Risk: Randomness where probabilities are known.
- Uncertainty: Randomness where probabilities are unknown.
He underlines the critical role of entrepreneurs in the economy by assuming the risk associated with economic activity.
The Entrepreneur’s Role and Profit
For Knight, the main function of the entrepreneur is to ensure the income of production factors by bearing the risk of the company’s economic activity. The employer acquires the factors of production at a known price but must make predictions about future demand, which is uncertain regarding both the quantity sold and the final selling price.
Therefore, the entrepreneur assumes risk, and profit is the reward for assuming this risk. Knight defines profit as an uncertain residual benefit.
The Employer’s Risk Exposure
The employer runs the risk that their demand forecasts are unmet, potentially leading to unachieved objectives and losses. The employer faces certain costs but uncertain revenues, dependent on whether their expectations materialize.
Knight’s Main Contribution
Knight’s primary contribution is treating uncertainty as an essential element of business. The forecasts the employer must make include:
- Meeting consumer needs and estimating demand.
- Determining selling prices.
The degree of uncertainty—and thus the success of the predictions—depends on the employer’s available information and knowledge.
Types of Uncertainty
Knight identifies two types of uncertainty:
- That which can be reduced to a probability of occurrence.
- That which cannot be measured by probability.
In the first case, we are dealing with risk. Risk is the measure of uncertainty within the economic system. The risk borne by the entrepreneur justifies the employer’s profit. This is influenced by the employer’s attitude toward risk: aversion, indifference, or preference.
Categories of Risk
Risk may be of two types:
- Technical Risk: A measure of uncertainty associated with product outcomes under specific conditions and characteristics.
- Economic Risk: A measure of uncertainty where sales revenue might not exceed costs.
When uncertainty is measurable (i.e., it is risk), it can potentially be eliminated, as the risk may be covered by insurance. An insurance company assuming the risk would, however, impede some functions of the employer.
Distinction Between Director and Employer
Knight distinguishes between two different roles:
- The Director: A person who issues orders for business management and serves the organization.
- The Employer: A person who assumes the risk and chooses the director who manages and gives orders in the company.
The entrepreneur is the owner of the company (assuming the risk) and not necessarily the director. Although the owner and director may be the same person, the employer is the one who selects the director and assumes risk in situations of uncertainty. The employer commits funds in anticipation of an uncertain payoff, which serves as the reward for assuming that risk.