Uncertainty-bearing theory of entrepreneurship

May 12, 2020

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 lassez-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 the 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 on the right hand side of the chart.

The uncertainty-bearing theory obviously views entrepreneurs as bearers of uncertainty making it a very individualistic theory to start out with. The theory places great emphasis on the entrepreneur’s ability to make decisions under uncertainty. The uncertainty perspective 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—the greater their self-confidence, the more they can take on. Thus, uncertainty bearing is a capability that is innate or developed and using it to bear uncertainty in an entrepreneurial context is a normal cost of doing business or "cost of production", where the payoffs are indefinite, future, and based on hope and theories.

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.

Cognitive Load

Uncertainty causes a kind of cognitive load that is not worth the trouble unless the payoff is very large. For instance, Andy Grove described smaller business opportunities as distractions because compared to the size of the core business, their potential was tiny, but the cognitive costs to the organization (in this case, Intel) were great. He advocated for periodic vectoring, which served to cull many of the projects that strayed from very large payoffs.