From the Perfect to the Imperfect
7. Uncertainty

One kind of information is by its very nature impossible to get perfectly straight, no matter how honest or inquisitive people are. It is information about the future. Who doesn't want to know what the future has in store, but the future is unyielding. So we mortals are doomed to cope with uncertainty. Right now you do not know how you will do on your final exams, and we do not know how well you like our book. Yet we cope. We take a risk spending our intellectual resources now in the anticipation of major future returns in the form of grades, appreciation, and income. You take another risk too, by investing in a discipline that may or may not serve you well in your future life (we think it will, no matter what you do in the future).

Uncertainty is pervasive. Think of the uncertainties that we experience when looking for a job. So much we do not know. We do not know, for example, how our skills will be appreciated, how good the other applicants are, how good the jobs offered really are, whether to wait for another job and thus take risks and so on. Even enthusiasts for free markets are known to get second thoughts when they are trying to get a job.

Maria: I knew it all along. Markets are not much fun. Professor McCloskey, how can you like them so much?

McCloskey: I like markets for what they do for us. They are most efficient in allocating scarce resources and directing us to do whatever is best for us. Even if markets serve a social good individuals may suffer. People lose their jobs in markets, or their farms. And people can experience trouble finding a job. But let's not be distracted too much by the personal details and keep our eyes fixed on the social good. If markets are allowed to work, everybody will benefit in the end.

Klamer: You're too optimistic. Markets do not work that well; people do lose in markets and may suffer permanent damage. A fifty year-old steelworker is not going to find another dignified job. People's savings are wiped out when the economy slows down, setting them back for a lifetime. The uncertainties of your ideal market-society cause agony and suffering all-around.

Ziliak: Arjo, even I think you exaggerate. You do not give markets enough credit. Or you say "not" and "wiped out" and "lifetime" and "agony" when a careful assessment of the situation would suggest other words: sometimes, diminished, for awhile, frustration, in other words, less pain.

Rodney: It's interesting to hear professors arguing with each other. Enlightening, always, but also sometimes surprising!

Insurance and future markets

Markets do not only cause uncertainties, they also offer deals to reduce them. Think of the many kinds of insurance for sale. You can insure yourself against the risk of your getting ill, against fire, theft, death of a loved one, earth-quake damage; professional piano players can insure themselves against a hand that goes limp.

Businesses can cover future risks in the so-called future markets. Say a company needs to have one million Japanese yen a year from now to pay for a shipment of flat computers screens at that time. The uncertainty that it faces is the dollar price for one million yen. The company looses when the dollar price of yen goes up. To save themselves some headache the managers of the company may choose to buy themselves security in the futures market. They do so by entering into a contract that obliges them Japanese yen at the future date for a stipulated price. For this bit of insurance they pay a price, which is the price that someone else is demanding as compensation for the risk he or she runs by entering this deal.

Futures markets are markets in contracts for future deals.


But insurance does not always work. Some risks are simple not calculable and therefore uninsurable. A famous American economist, Frank Knight (1885-1972) reserved the term uncertainty for the condition that people have no basis for knowing what will happen, or even for calculating the risk.

Uncertainty is the condition in which agents have no basis for knowing or what is the case, or for calculating the risk.

This applies to events that are unique in any way. Keynes, the famous British economists, was adamant about the distinction between risk and uncertainty:

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being withdrawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever.

J. M. Keynes, "The General Theory of Employment" The Economic Journal, February 1937

Each market society develops a complex set of institutions to frame and guide life in markets and thus to reduce the uncertainties. Institutions here comprise all rules, customs, conventions, norms as well as laws that constrain behavior in some way or another, this in contrast to the everyday meaning of "organizations." An example is the law that protects property rights which constrains people from taking whatever they please and give security to the owners of whatever is wanted.

Institutions are the rules, conventions, customs, norms as well as laws that constrain (economic) behavior and thus reduce uncertainties.

Contracts are among the uncertainty reducing institutions. When you want to get a loan you enter the market for financial funds. To save you the hassle to do so every other month or so, the bank of your choice and you agree on a contract that will fix the deals for a certain number of years. The contract removes the uncertainty about those future deals.

Another example of an effective institution is the norm to be honest. It's an effective institution because it's easy to do business with people who adhere to that norm. Lawyers would be superfluous, for instance, and that keeps transaction costs low. Honesty is still the norm in many small communities. There customers can trust the car mechanic and the plumber to do a honest job freeing them from a lot of agony, suspicion, and frustration. Unfortunately, the norm is hard to maintain in larger communities. For where honesty prevails, there is an incentive to cheat. When admission officers of colleges trust applications to be honest, an unscrupulous character can inflate his resume knowing that it won't be checked. Without social enforcement, systems that rely on honesty tend to break down. That's why honesty has to be taught by parents, schools, and bosses.

Institutions also constrain and guide business decisions. Uncertainty about pricing decisions may encourage companies to follow "rules of thumb," such as the rule that the price equal unit costs plus a 10 percent extra for profit. Real estate agents throughout the U.S. adhere to the convention that the total commission on a sale is six percent of the selling price. No more, no less. An alternative convention would be to charge for each hour of work done. That would make an easy sale cheaper than under the current convention. The latter, however, reduces the uncertainty and simplifies the interactions between agents and their clients.

Concept Check 7: Think of institutions that reduce the uncertainty in the market for a college education.


Uncertainty is not always a bad that is to be avoided at all expense. It can be also the spice of life. Speculators and gamblers thrive on it. And entrepreneurs, whom we encountered in chapter 15 as one of the factors of production, exist because of it. Entrepreneurs are those persuasive visionaries who break with routines and tread where others don't dare to go or can't even imagine ever going. The entrepreneurial types among students start a business while still at school sees an opportunity for a profitable business, goes against the odds, overcomes the doubts of well-willing friends and parents, persuades financiers to take some risk, and succeeds in realizing the plans.

Entrepreneurs, therefore, exploit the uncertainties in the economy. They cope by making bold plans and using their persuasive powers to commit others to their schemes. Many entrepreneurs fail. Either they can not get the needed funds or, when they do, they may not persuade potential buyers. Entrepreneurship is tough. That's why not everybody is made for it.