Frank Knight and Ellsberg's Paradox
This is not about other posts on the Internet, but rather the reeling of my tired brain while I was stuck in traffic today....and boy, I hope this post - more than any other - elicits comments...
(But feel free to scroll down to the next post if this starts to put you to sleep)....
Last summer I finally read Daniel Ellsberg's classic, Risk, Ambiguity, and Decision (just republished in hardcover), which includes the famous Ellsberg Paradox and the "balls-in-the-urns" experiments. (Simplified explanation for those unfamiliar: these were experiments documenting that people are more averse to uncertainty than they are to regular risks of known proportions, usually to an irrational degree). I was confused, honestly, that I could not find a reference to Frank Knight's earlier classic, Risk, Uncertainty, and Profit anywhere in Ellsberg's book. This seemed strange because Knight is generally credited with being the first to draw a conceptual distinction between risk and uncertainty (a distinction that is still controversial). Another book I read at the same time, Judgment Under Uncertainty (Kahneman, Slovic & Tversky) seemed to make the same omission, unless the reference happened while I was sleep-reading (very possible).
So, sitting in traffic today, I was thinking about Knightian uncertainty and the "Unconscionability Doctrine" in Contracts (a project I've been working on since last summer that has so far gone in circles). The rule is disfavored by creditors, of course, because it provides an opportunity for losses from defaulters - and most of the arguments against the rule seem to run along the lines that it disproportionately burdens the very businessmen and financiers who offer the most transactional opportunities to the poor (besides criticisms of the rule's overall inelegance). There is thus a chilling effect on opportunities for the poor. Valid concerns, of course. But there is something else going on with this rule: it is not just about tipping the scales slightly to one side or the other (like most legal rules), but is actually sort of an "anti-rule," and undefined, squishy, equitable loophole that allows a court to "break" the usual bright-line rules in Contracts. It constitutes the introduction of uncertainty into the transactions, for both parties, besides the supposed costs of insuring against default, etc. (which are simple, actuarial risks under Knight's paradigm). According to Knight, this introduction of uncertainty should create the possibility of "true profits" (for both sides?) where the possibility would not otherwise exist - perhaps encouraging transactions. Yet Ellsberg (I think) would indicate that the introduction of uncertainty brings in a chilling effect on transactions, besides any chilling effect from the rules being pro-consumer. This is where I end up every time I start working on this project - with this "unconscionability paradox" or contradiction, a circle I never break out of. Sigh.
I did, however, think of something else that helped me connect Knight's ideas with the Ellsberg Paradox (somebody be kind enough to email me if everyone else already knew this): Knight, after spending his whole book building up his definition of entrepreneurs, risks, uncertainty, and profit (which I think most of us would call "windfall" as a more descriptive term), says in the last chapter that he suspects uncertainty works in the negative in the aggregate. In other words, the aggregate amount of windfall profits realized by successful entrepreneurs in society is outweighed by the aggregate losses of the unsuccessful entrepreneurs. He concludes that entrepreneurialism must constitute an overall net loss for society as a whole, then admits that this is really confusing because it goes against the foundational assumptions of capitalism - and then quickly says farewell and ends his book (and then the Great Depression happened).
If Knight is right (I like how that rhymes), this would certainly add a touch of legitimacy and intuitive rationality to Ellsberg's Paradox, wouldn't it? Aversion to uncertainty - in fact, the greater aversion to uncertainty than to quantifiable (read insurable) risk - makes a lot of sense if it is a losing proposition for the species overall. Well, maybe this will strike others as a good case for listening to talk radio in traffic instead of letting my mind wander. But for me, Ellsberg's Paradox just moved from the category of "bounded rationality" into classic Posnerian rationality, and the wedding between Knight's ideas and Ellsberg's was complete. Next step is to talk myself out of the unconscionability thing...
(But feel free to scroll down to the next post if this starts to put you to sleep)....
Last summer I finally read Daniel Ellsberg's classic, Risk, Ambiguity, and Decision (just republished in hardcover), which includes the famous Ellsberg Paradox and the "balls-in-the-urns" experiments. (Simplified explanation for those unfamiliar: these were experiments documenting that people are more averse to uncertainty than they are to regular risks of known proportions, usually to an irrational degree). I was confused, honestly, that I could not find a reference to Frank Knight's earlier classic, Risk, Uncertainty, and Profit anywhere in Ellsberg's book. This seemed strange because Knight is generally credited with being the first to draw a conceptual distinction between risk and uncertainty (a distinction that is still controversial). Another book I read at the same time, Judgment Under Uncertainty (Kahneman, Slovic & Tversky) seemed to make the same omission, unless the reference happened while I was sleep-reading (very possible).
So, sitting in traffic today, I was thinking about Knightian uncertainty and the "Unconscionability Doctrine" in Contracts (a project I've been working on since last summer that has so far gone in circles). The rule is disfavored by creditors, of course, because it provides an opportunity for losses from defaulters - and most of the arguments against the rule seem to run along the lines that it disproportionately burdens the very businessmen and financiers who offer the most transactional opportunities to the poor (besides criticisms of the rule's overall inelegance). There is thus a chilling effect on opportunities for the poor. Valid concerns, of course. But there is something else going on with this rule: it is not just about tipping the scales slightly to one side or the other (like most legal rules), but is actually sort of an "anti-rule," and undefined, squishy, equitable loophole that allows a court to "break" the usual bright-line rules in Contracts. It constitutes the introduction of uncertainty into the transactions, for both parties, besides the supposed costs of insuring against default, etc. (which are simple, actuarial risks under Knight's paradigm). According to Knight, this introduction of uncertainty should create the possibility of "true profits" (for both sides?) where the possibility would not otherwise exist - perhaps encouraging transactions. Yet Ellsberg (I think) would indicate that the introduction of uncertainty brings in a chilling effect on transactions, besides any chilling effect from the rules being pro-consumer. This is where I end up every time I start working on this project - with this "unconscionability paradox" or contradiction, a circle I never break out of. Sigh.
I did, however, think of something else that helped me connect Knight's ideas with the Ellsberg Paradox (somebody be kind enough to email me if everyone else already knew this): Knight, after spending his whole book building up his definition of entrepreneurs, risks, uncertainty, and profit (which I think most of us would call "windfall" as a more descriptive term), says in the last chapter that he suspects uncertainty works in the negative in the aggregate. In other words, the aggregate amount of windfall profits realized by successful entrepreneurs in society is outweighed by the aggregate losses of the unsuccessful entrepreneurs. He concludes that entrepreneurialism must constitute an overall net loss for society as a whole, then admits that this is really confusing because it goes against the foundational assumptions of capitalism - and then quickly says farewell and ends his book (and then the Great Depression happened).
If Knight is right (I like how that rhymes), this would certainly add a touch of legitimacy and intuitive rationality to Ellsberg's Paradox, wouldn't it? Aversion to uncertainty - in fact, the greater aversion to uncertainty than to quantifiable (read insurable) risk - makes a lot of sense if it is a losing proposition for the species overall. Well, maybe this will strike others as a good case for listening to talk radio in traffic instead of letting my mind wander. But for me, Ellsberg's Paradox just moved from the category of "bounded rationality" into classic Posnerian rationality, and the wedding between Knight's ideas and Ellsberg's was complete. Next step is to talk myself out of the unconscionability thing...
Comments
The fact that you have now have a blog is perhaps the greatest thing ever. for a man with so much to say, it is amazing it has taken you until now to join the club.
for what it's worth, don't discount uncertainty...the chance to take that leap, with no safety net below. for some, it's what makes this life worth living.
Thanks for your comments! I actually agree with you, and I am still mulling this over (and will continue to mull over your suggestions as well). I wasn't sure if the aside about enhancing my school was tongue-in-cheek or serious, but I decided to take it as a compliment so I'd have a better day.
You may be right, uncertainty analysis may have no useful application here.
What keeps me coming back to this, however, is the idea that the UD is so open-ended that it is applied unpredictably, unlike a typical consumer-protection statute. Rates of unrecoverable loss via default, under a consumer-protection law, are easy for actuaries to determine and for businessmen to offset by increasing their rates generally. Businesses can self-insure against any quantifiable risk, and consumer default is statistically determinable.
I just wonder if the UD introduces some real chaos into this assessment. Prevailing as a consumer under UD is very rare, and seemingly unpredictable and haphazard in frequency. I wondered if it would be difficult for business owners to predict their losses under this particular rule, as opposed to the rates of consumer default generally.
I also wonder if transactional rules that initially appear to favor one party (like consumers) may actually cut both ways. I get it that consumer protection laws often backfire because businesses either increase rates to offset their new losses, or withdraw from the lower-end niche of the market entirely. But common-law UD is a gamble for consumers; it is not a good security blanket. And when the consumers lose, the business wins in that case. It seems that UD claims usually do not work well for the consumer, meaning that having the rule provides plenty of opportunities for the business to go ahead and exploit without a loss. It's like a bet, in that sense. The presence of UD may encourage some consumers to bet that they can make a contract, default, and walk away with a windfall; and it's not a bad bet for the businesses to match, because of the increased opportunity to exploit and get away with it in an unpredictable number of cases.
Sigh. Like I said, I have not been able to write anything good about this since last summer, because I keep coming back to concepts like the ones you raised.
Upon reflection, I suppose my point is that maybe the uncertainty principle doesn't apply in the UD context because the risk is quantifiable. That is, either party could determine the economic impact of worst case application of UD, such as unenforceability of the contract. Even with the "uncertainty" of whether UD would be applied and to what extent on a case by case basis, at least the downside risk exposure, in $ terms, could be determined.
So if I have a t.v. worth $50 and agree to sell it to you (hypothetically) for $100 - $40 today and $60 next week (because you're a deadbeat, and there's a great chance you won't pay next week - ignoring usury), I'll know that even if UD is applied, my maximum loss is $50 (the FMV of the item), or $100, if opportunity cost is the measuring stick, perhaps less if I get the t.v. back when the transaction is unwound by UD.
STCL '95
Thanks for your comment! I wonder if one of them already did that, but it was buried in the calculus section in one of the articles, which I confess I usually sort of skip over.... :-)