Doubt and hope in economics: A review of Kiyohiko G. Nishimura and Hiroyuki Ozaki's Economics of Pessimism and Optimism

• Published date: 01 May 2019
• Author: Ken Kasa
• DOI: http://doi.org/10.1111/infi.12341
• Date: 01 May 2019

© John Wiley & Sons Ltd wileyonlinelibrary.com/journal/infi International Finance. 2019;22:118–122.

118

Nearly a century ago, Knight (1921) proposed a distinction between “risk”and “uncertainty.”Risk

describes situations where an explicit probability distribution of outcomes can be calculated, perhaps

on the basis of past data. In contrast, uncertainty describes situations where probabilities are unknown,

and, more importantly, where they are impossible to calculate with any confidence due to lack of

relevant data. Knight argued that “profits”should be defined as the reward to bearing uncertainty.

The concept of Knightian Uncertainty has always been attractive to economists. For example,

Keynes attributed the volatility of financial markets to Knightian Uncertainty (although he did not call

it that). However, Knightian Uncertainty turned out to be difficult to formalize. In fact, Savage (1954)

pointed out that, even when it is impossible to construct an explicit probability distribution, people

nonetheless manage to make decisions and resolve trade-offs, and under certain axioms, these

decisions reveal the implicit probabilities they assign to ambiguous outcomes. Whether these

probabilities are “objective”and based on relative frequencies, or whether they are “subjective”and

based on individual beliefs, was shown to be irrelevant to the analytics of decision-making.

During the past two decades there has been a revival of interest in Knightian Uncertainty. This was

partly due to mounting empirical evidence casting doubt on the Savage axioms, the most well known

being Ellsberg's (1961) famous urn experiments. However, it was also partly due to theoretical

advances during the late 1980s, which showed how to relax the Savage axioms in a way that delivers a

workable model of Knightian Uncertainty. After all, “it takes a model to beat a model.”

The recent monograph by Nishimura and Ozaki, entitled Economics of Pessimism and Optimism:

Theory of Knightian Uncertainty and Its Applications, provides a summary of this exciting new

research. They are well equipped to take on this ambitious project, as they are both active participants in

this literature. In fact, several of the chapters are based on their own work. The book consists of 15

chapters. Chapter 1 provides an introduction and overview. The next two chapters provide background

on probability and decision theory. Chapters 4–6 develop the theory in simple static settings. The

applications here focus on Dow and Werlang's (1992) model of portfolio inertia and Dana's (2004)

model of equilibrium indeterminacy. The heart of the book consists of chapters 7–14, which develop

dynamic models of Knightian Uncertainty. Chapter 7 uses results from Ozaki and Streufert (1996) to

show how dynamic programming can be applied with Knightian Uncertainty. Chapter 8 returns to

equilibrium indeterminacy, with a focus on Epstein and Wang's (1994) asset pricing model. Chapter 9

Doubt and hope in economics: A review of

Kiyohiko G. Nishimura and Hiroyuki Ozaki’s

Economics of Pessimism and Optimism

Ken Kasa

Simon Fraser University at Harbour Centre, Vancouver, Canada

ECONOMICS OF PESSIMISM AND OPTIMISM: THEORY OF KNIGHTIAN

UNCERTAINTY AND ITS APPLICATIONS

Kiyohiko G. Nishimura and Hirojuki Ozaki

Springer Japan KK, Tokyo, 2017

DOI: 10.1111/infi.12341

BOOK REVIEW

Knightian uncertainty

Knightian uncertainty

Knightian uncertainty

Knightian uncertainty

Knightian uncertainty

Knightian uncertainty

Knightian uncertainty

Knightian uncertainty