Uncertainty-Bearing Theory of Entrepreneurship

Frank Hyneman Knight, an American economist at the University of Chicago, developed the uncertainty-bearing theory in the 1920s to explain the phenomenon of entrepreneurship.

The Roaring 20s

The roaring 20s brought with them renewed attention to the people and processes that served to bring innovations to market with increasing intensity, and the media of the day was in the habit of idealizing business tycoons. Much of the government had adopted a laissez-faire attitude toward business.

Knight distinguished between risk that can be modeled probabilistically, from uncertainty, for which the probabilities are unknowable. For instance, uncertainty surrounds the implementation of new strategies, the development of new products or entry into new markets. Similarly, the positive consequences of acquiring a competitor may have unknowable probabilities.

According to his theory, bearing business uncertainty creates profit and the more uncertainty taken on, the more profit can be gained. The relationship between uncertainty and gain may be linear, or even exponential, where there are bigger payoffs when the uncertainty born is greater.

The uncertainty-bearing theory views entrepreneurs as bearers of uncertainty. The theory places great emphasis on the entrepreneur’s ability to make decisions under uncertainty. The uncertainty perspective also suggests a normative dimension: that entrepreneurs who are willing to take on great uncertainty may deserve windfall profits the rare times they do succeed.

Entrepreneurs take on uncertainty according to their inclinations and abilities. Knight argued that the greater their self-confidence, the more they can take on. Thus, uncertainty bearing is a capability that is is a normal cost of doing business, where the payoffs are indefinite, future, and based on hopes and conjectures.

Pooling Uncertainty Bearing

The theory also suggests that uncertainty can be reduced through pooling it among several entrepreneurs. Broadly pooling uncertainty may be especially important when pursuing windfall profits because the reward will be large enough to compensate several participants. Pooling may be less important for smaller payoff opportunities because they may not supply enough reward to make sharing worthwhile.

Institutions to Mitigate Uncertainty

Frank Knight (1921) saw the world as an environment that constantly brings new opportunities for businesses to form and make money. However, with these new opportunities also come new risks. 

Knight observed that one reason humans developed institutions, such as financial firms, is to help eliminate the uncertainty that comes with entrepreneurship (Emmett, 2011). Stable institutions and regulations help reduce uncertainty by creating more predictable future outcomes.

Sources:

Emmett, R. B. (2011). Frank H. knight on the "entrepreneur function" in modern enterprise. Seattle University Law Review, 34(4), 1139.

Knight, F. H. (1921). Risk, Uncertainty and Profit. The Riverside Press Cambridge.