The role of risk versus the role of uncertainty in economic systems

Frank Knight made an important distinction between risk and uncertainty – a distinction that continues to be blurred in economists' writings to this day. At one extreme is pure risk where probabilities can be numerically assigned exactly from objective, physical data. This is actuarial risk. At the other extreme is pure uncertainty, which Knight claimed is unanalyzeable. Random variables for many economic problems appear to fall somewhere between these two extremes, but in the rapidly changing global economic system, random variables appear to be characterized by more and more uncertainty. Yet, methods and methodology typically employed in theoretical and empirical analyses of economic systems were developed for the case of pure risk, then imposed on problems characterized by uncertainty. Systems modelers need to better recognize the uncertainty dimension of many problems, including the role of uncertainty in the potential instability of market systems and in Knightian welfare economics. New methods and methodology may be required to properly model uncertainty.