Uncertainty vs Risk

Understanding the difference between uncertainty and risk. In situations of uncertainty, economic agents cannot assign a probability to future events. By contrast, in situations of risk, each potential outcome can be linked to a specific, quantifiable probability.

Take the example of a player betting on the number 1 before rolling a die. This is a case of risk because the probability of that outcome is known and measurable - 1 in 6. Conversely, there's no way to know in advance how many times the die will bounce across the table after being rolled. In this second scenario, the player lacks sufficient information, making it a case of uncertainty.

The distinction between risk and uncertainty was formally introduced in economic theory by American economist Frank Hyneman Knight. In the 1920s, Knight published his influential book "Risk, Uncertainty and Profit", in which he offered a foundational definition of risk in economic terms. According to Knight, a situation qualifies as risky only when the probability of an outcome can be objectively calculated. Only in these circumstances can the event be insured against. If the event is fundamentally unpredictable - meaning no objective probability can be assigned - then the concept of risk does not apply, as neither insurers nor policyholders have sufficient information to assess the likelihood of occurrence.

Knight’s definition clearly delineates which events are insurable and which are not. His framework was widely adopted by economic theory between the 1930s and 1950s, which restricted the analysis of decision-making under uncertainty to cases where future events could be assigned objective probabilities.

However, this sharp distinction fades in the context of subjective expected utility theory, where economic agents can make decisions even without objective probabilities or historical data. In such models, individuals form subjective estimates regarding the likelihood of future events. Since these assessments are not grounded in objective data, they fall outside Knight’s definition of risk. As a result, subjective choice theories have expanded the scope of economic analysis to include scenarios that were once deemed beyond the reach of traditional political economy, effectively softening the conceptual boundary between risk and uncertainty.