Risk vs. Uncertainty

Oct 8, 2022

Imagine a game where you pick a red or green ball out of a bucket. If you pick red, you win $100. Which bucket would you rather choose?

  • Bucket A with exactly 50 red balls and 50 green balls.
  • Bucket B with 100 red or green balls, with unknown distribution.

Most people prefer Bucket A, despite both buckets having the same expected utility. This is because we tend to choose the less ambiguous option when it comes to quantifiable vs. unquantifiable risk. Our tendency towards ambiguity aversion, even when the expected utility is greater, is called the Ellsberg paradox.

Incumbents greatly prefer risk over uncertainty, and startups can take advantage of that.

Frank Knight, one of the founders of the Chicago school of economics, wrote in his book Risk, Uncertainty, and Profit,

Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.