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Uncertainty in Economic Thought

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Uncertainty in Economic Thought Part I Uncertainty in Economic Thought Uncertainty has various facets in economic thought and a history that goes back to the founding fathers of political economy. David Hume and Adam Smith emphasised the importance of uncertainty for the economic development and explained the existence of economic allocation problems both with scarcity of resources and ambiguity, which originates from uncertainty and limited human knowledge. Furthermore, they have identified uncertainty to be a serious challenge to the aspired scientificness of economics. Particularly, Hume demanded for ideal- istic and abstract mathematical reasoning in economics, because uncertainty impedes any realistic science. This plea for abstract theories in the face of uncer- tainty has been followed up by William Stanley Jevons (1863, 1871), Carl Menger (1871) and Le´on Walras (1874) during the so-called marginal revolution. They developed the theory of the utility maximizing economic agent under conditions of certainty. Later, Jevons extended this theory to conditions of risk, by assigning objective probabilities to the utilities of some agent. However, in most economic decision-making no objective probabilities can be assigned, so that this economic theory of rational choice was rather limited at the beginning of the twentieth century. New developments in the theory of probability during the 1920s and their integration into the economic theory of choice during the 1950s and 1960s, allowed for the extension of the rational choice framework to situations in which objective probabilities were missing. These situations became defined as situations of uncer- tainty in Neoclassical Economics. From that time on, uncertainty was equivalent to subjective probabilities in economics (also called the Baysian theory of uncertainty, I call this the Neoclassical Uncertainty Paradigm). The first part traces the emergence and development of the Neoclassical Uncer- tainty Paradigm and discusses its underlying methodology. Particularly, the differ- ent theories of probability underlying the economic theory of choice under conditions of imperfect knowledge, such as risk and uncertainty are analysed critically. Also, the emergence and development of the concept of probability is presented in detail. This analysis allows understanding the concept of probability on 16 I Uncertainty in Economic Thought the background of its emergence and shows that probability is originally a measure of ignorance, which was later turned into a measure of belief. Nevertheless, it is used in economics as if it would allow for a rational and unambiguous analysis of economic decision-making. The analysis shows that rational choice theory and the different theories of probability were originally designed as analytical instruments with limited scope and limited applicability to real economic problems. They are devices of an abstract and elegant, idealistic and closed body of theory. The Neoclassical Uncertainty Paradigm was originally neither designed to be the basis of modern economic theories that operate under conditions of uncertainty, nor does it cover the problem of uncertainty in economics by any means. The theory is analytically brilliant and at the same time fundamentally flawed, as it misrepresents the problem of uncertainty in economics by all means and therefore leads to a structural underestimation of its impact on the economy. References Jevons WS (1863) A general mathematical theory of political economy Jevons WS (1871) The theory of political economy. Palgrave Macmillan, London Menger C (1871) Grundsa¨tze der Volkswirtschaftslehre. Mohr Siebeck, Tübingen Walras L (1874) E´ le´ments d’e´conomie pure ou the´orie de la richesse sociale.
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