No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Ten: It’s all About the Institutions! 231 possibilities: a head or a tail. If the coin is fair, the probability of a head is one-half (or .5), while the probability of a tail is also one-half; as we commonly say, the probability is 50-50. So for every coin toss at the beginning of an NFL game, the players making the call face risk, but they do not face uncertainty. The coin is going to come up either heads or tails. If it’s a fair coin, a large number of tosses would yield roughly an equal split between heads or tails. Situations that are uncertain, however, have no basis for calculating a probability. For example, what is the likelihood of a football team getting a holding call on the first drive after the third quarter begins? How can we possibly know whether a penalty will be called? While we may not have any basis for assigning a probability—so that it’s uncertain versus risky —we may still know something about it. Perhaps we know that the opposing team has a great pass rush that creates many quarterback sacks and therefore opposing teams often get called for holding. Thus we may expect that a holding call is more likely this week than last week. Or we may know that our starting tackle is out this week and the backup isn’t as good; perhaps he’s more likely to hold and get a penalty. These facts help us somewhat answer the question. We’re not totally in the dark, but we don’t know what the outcome is going to be. However, as time progresses and the game plays, our ability to hazard a guess gets better because we gain new knowledge. If our offensive line is doing a standup job with no holding calls thus far, and our ground game has taken control of the game such that we’re winning 28-7 at half-time, we now know we’re likely to be running the ball most of the time to run out the clock. Since running plays get holding calls much less frequently than passing, we can imagine holding calls as “less likely” on a given play as the game goes on, despite the fact that we can’t assign a probability and that the question of a holding call is still uncertain. We face ignorance when the question is first asked, but as we gain more knowledge, we are increasingly able to make better assessments. The football game is a process where we discover more information about a number of things that help us “know” the expected result. We begin to see how strict the referees are at making calls, we see how tough the defensive line is, how our new tackle is holding up, how our game plan is stacking up against the other team’s, etc. As we gain this new knowledge we are better able to understand the likelihood of a particular outcome on a given play. The market process is similar in this regard; it is governed predominantly by uncertainty rather than risk. Market participants face initial ignorance as to others’ plans and preferences. But as they go through the process, they learn and make adjustments to their plans to more fully coordinate their actions with others’. Entrepreneurs may have an idea of a product to build. They may anticipate a certain level of demand and possible prices they may be able to receive, but until they actually offer the product they won’t know what the actual demand is. Similarly, they estimate the resources that it will require to produce the good or service, but until they actually start production, they don’t discover what the actual costs are. They may have an idea “The market process…is governed predominantly by uncertainty rather than risk”