Your Mother Loved You But She Died: A Note on Profit

Tyler Cowen offers up an odd response to Nassim Taleb in Tyler's review of The Black Swan, Taleb’s new book about prediction and unlikely events (link). Here’s Tyler:

Taleb does insist on the originality of his work—regarding it as a black swan, of course—and refers to opposing views as the "GIF: Great Intellectual Fraud." Nonetheless, the idea of a Power Law as a deeply skewed and asymmetric distribution is well-known, and the statistical notion of "ergodicity" (roughly, the idea that the initial state of a system does not predict its end state very well) has been around for a long time. In 1921, economist Frank Knight drew a distinction between unquantifiable and radical uncertainty and the risk of flipping a coin or playing a roulette wheel. If these ideas have not always been part of the mainstream, it is because they can quickly prove intractable, not because they have been suppressed by an arrogant scientific community.

I won’t defend “GIF”—and FWIW, I am not an economist and Tyler is. But I do think he is eliding over an important point here. I am the proud owner of a cherished first edition of Frank Knight’s Risk, Uncertainty, and Profit (1921), surely one of the classics of modern economics. Knight’s point, only slightly restated, is that an “expected profit” is a contradiction in terms—it may be a “factor return,” but in a competitive market, it will be no higher than the opportunity cost of capital, and the net present value of a project will be zero. So, consider the case I buy a share of BigCo, with a certain return at t=1 of $100. I pay $80 at t=0: that is a 25 percent return ((100/80)-1=0.25=25 percent). But suppose the market rate of return for comparable investments is 10 percent. Then I can’t really expect to get it for $80; I can expect the price to be bid up to $90.91, where the implied rate of return is the market rate ((100/90.91)-1=0.1=10 percent).

By Knight’s analysis, there is a “profit” in this deal--$10.91, being spread between the $90.91 “implied return,” or “opportunity cost return,” and the $80 you pay. But blink your eyes and it won’t be there any longer. That's the definition of a competitive market. That’s why economists say that if there is a five dollar bill on the street in your neighborhood, it isn’t there any longer. The guy who gets the profit is the guy who, by superior acumen or dumb luck, grabs the opportunity before anybody else knows what it is worth. Or more brutally, your mother loved you but she died.

Economists and others like to use models from, e.g., casino gambling, to suss out the analysis of risk. The point here is that these casino gambling returns are, over the long run, highly predictable. Indeed, I have had students argue that casino gambling isn’t even risk—that they can set aside money for it as part of their entertainment budget, just as they might put aside money for food, or rent, or tuition. My only response is—what are students doing with that kind of money anyway?

The trouble with mainstream theory is not that it denies this kind of profit, but that it doesn’t know how to model it. And if something doesn’t get modeled, it might as well be denied. This is, by the way, one point on which the “Austrians” score points against (and differ from) the mainstream—one thing that they are driving at when they rattle on about the importance of “entrepreneurship” in economic behavior (see, e.g., link). The corollary is that the Austrians disdain this kind of modeling, and without a model, you don’t get no respect.

This is, by the way, just one of many ways in which Frank Knight’s startling originality and prescience gets smoothed over in mainstream theory. Economists are human: when they squat around the campfire to drink the blood of the vanquished, they like to retell their story in linear narrative, with Knight as a precursor. So he is, but it is a shame to sacrifice his originality to the demons of linearity.

My very best wishes to Tyler’s mother, with high hopes for her good health and long life.