2 Uncertainty in Economics*

There are two different concepts of uncertainty in economics: the classical

concept and the Keynes concept. The ability of economists to explain the
importance of money, liquidity and the existence of persistent unemployment
in a market economy depends on which concept of uncertainty the analyst
uses.

1 DECISION-MAKING IN ECONOMICS

The economy is a process in historical time. Time is a device that prevents

everything from happening at once. The production of commodities takes
time; and the consumption of goods, especially durables, takes considerable
time. Economics is the study of how households and firms make decisions
regarding production and consumption when the outcome (pay-off) of
today's decision occurs at a significantly later date.
Any study of the behaviour of economic decision-makers, therefore,
requires the analyst to make some assumption regarding what today's
decision-makers 'know' about future outcomes. Because economists are split
into two major theoretical camps about the meaning of uncertainty regarding
future outcomes, and therefore what decision-makers know about the future,
these groups provide differing explanations of economic problems and their
policy solutions. Understanding the differences in these two concepts of
uncertainty is essential to understanding the philosophical differences
between economists on the role for government and economic policies in
the economic system.

2 THE ABSENCE OF UNCERTAINTY IN NINETEENTH-CENTURY

CLASSICAL ECONOMICS

Ricardo (1817), the father of nineteenth-century classical economics,

assumed a world of perfect certainty. All households and businesses were
assumed to possess a full and correct knowledge of a presumed programmed
external economic reality that governed all past, present and future economic
outcomes. The external economic environment was assumed immutable in
the sense that it was not susceptible to change induced by human action. The
path of the economy, like the path of the planets under Newton's celestial

• This paper appeared in the Encyclopedia of Statistical Sciences, Vol. 2, by S. Katz, C. B. Read
and D. L. Banks (eds) (New York: Wiley 1998).

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L. Davidson (ed.), Uncertainty, International Money, Employment and Theory

© Paul Davidson 1999
 Uncertainty in Economics 31

mechanics, was determined by timeless natural laws. Economic decision-

makers had complete knowledge of these laws. Households and firms never
made errors in their spending choices. They always spent everything they
earned on things with the highest 'known' future pay-off in terms of utility for
households and profits for businesses. Accordingly, there could never be a
lack of demand for the products of industry or for workers who wanted to
work. Classical economics justified a laissez-faire philosophy for the economic
system. No government action could provide a higher pay-off than the
decisions individuals made in free markets.

3 UNCERTAINTY IN TODAY'S ORTHODOX ECONOMICS

In the early twentieth century, classical economists tended to substitute the

notion of probabilistic risk premiums and 'certainty equivalents' for the
perfect knowledge assumption of earlier classical theory. Risk premiums
provided uncertainty allowances where the latter referred to the difference
between the estimated value of a future event, held with an objective
(frequency distribution) probability of less than unity, and the value of a
perfectly certain (p = 1) event that evokes the same behaviour.
By the 1970s, this classical risk analysis had evolved into what economists
call the New Classical Theory of 'rational expectations' where individuals
make decisions based on their subjective probability distributions that are
presumed to be equal to immutable objective probability distributions (Lucas,
1972). Today's orthodox economists interpret uncertainty in economics as
synonymous with objective probability distributions (Lucas and Sargent,
1981; Machina 1987) that govern future events but are completely known to
all persons today. The standard deviation is the quantitative measure of
uncertainty.
This device of labelling statistically reliable estimates of probabilistic risk as
uncertainty, permits orthodox economists to preserve intact most of the
analysis that had been developed under the earlier perfect certainty
assumption. While rejecting the perfect certainty model, orthodox econo-
mists still accept, as a universal truth, the existence of a predetermined reality
(similar to Newton's celestial mechanics) that can be fully described by
unchanging objective conditional probability functions that are fully known by
the decision-makers in one's model. Unlike the perfect certainty model,
however, conflating the concept of uncertainty with the probabilitistic risk
permits individual decision-makers to make an occasional erroneous choice
(in the short run), just as a single sample means can differ from the true
universe value. In the long run, the assumption that people with rational
expectations already 'know' the objective probabilities assures correct choices
on average for those 'fittest' decision-makers who survived in the Darwinian
world of free markets.