Formula Elaboration # 2: Uncertainty

Let's say Carlos Zambrano, anchor of the Chicago Cubs rotation, faces St. Louis Cardinals superstar Albert Pujols, in a tight pennant race game. Each player has studied the other: pitch type, pitch sequence, hot and cold hitting zones, direction the ball is usually hit in, etc. When the bases are empty, Pujols has an informed guess of the likelihood that Zambrano will start him off on a fastball low and away. On any given count--1-0, 2-0, 2-1--Zambrano knows that Pujols swings X% of the time. The infield positions itself according to Pujols' directional probabilities, and the outfield will usually play Pujols deep.

Always a game conducive to statistical analysis, the last twenty years have seen a veritable explosion in the statistics used to analyze any possible outcome during a baseball game. Part of this goes under the name sabermetrics (a site we like is Baseball Prospectus), but you can see less mathematical derivations of it during any television broadcast: average with runners on second and third with two out, average with a 3-1 count, ERA during day games, etc.

But no matter how many formulae you throw into a particular situation, like one between Zambrano and Pujols, the outcome always remains indeterminate. It's often said that baseball is a game of inches, and slight differences in the trajectory or spin of the ball, the planar path of the swing, the angle at which the ball and bat meet can have enormous differences. (The "butterfly effect" in a different context.) Pertaining to another sport, David Foster Wallace has written excellently on all the different things that can affect the path of a racquet-launched tennis ball.

All of that is not surprising, but it just goes to show how much uncertainty remains even in a statistical-heavy endeavor like baseball. Moreover, the participants in a baseball game are only human, prone to mistakes and irrational decisions. The beautiful unpredictability of homo sapiens will always create copious amounts of uncertainty.

It also shouldn't surprise anyone that uncertainty is a major factor in the economy. Go back one year to the beginning of what is usually referred to as the "credit crisis." Canvass any news article in the subsequent year and you will continually find expressions of shock at how much we don't know and how murky the future directions of the U.S. and world economies are. It's as if it never occurred to them that uncertainty still lurked. (There are, of course, some hope-inspiring exceptions.)

But what does uncertainty mean? The idea that uncertainty plays a large role in economic affairs has come back into some form of fashion in recent years, mostly due to the fabulous work of Nassim Nicholas Taleb and his books, The Black Swan (the more popular one) and Fooled by Randomness (the better one). Still, Taleb would probably be the first to point out that economists and commentators appear to be consistently surprised at not only the impact of uncertainty but also the mere existence of uncertainty.

I say uncertainty is "back" in fashion because it has been recognized before in economic analysis. Two famous economists in particular, Frank Knight and Joseph Schumpeter, saw uncertainty as a critical element in the economic universe--the dark matter, we might say.

Here is Knight writing in 1921 in Risk, Uncertainty and Profit:

"It is a world of change in which we live, and a world ofuncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity. . . . If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary."

We'll leave the epistemology for the future, or for others (a favorite is Karl Popper). For now it is sufficient to note that Knight insightfully distinguished between two types of uncertainty. Risk, which could be quantitatively measured and thus known and accounted for; and "true" uncertainty, which is non-quantitative and "not susceptible to measurement and hence to elimination." It is this "true" uncertainty--the dark matter--that accounts for the existence of profit and entrepreneurship. (We'll return to entrepreneurship in a future post when we sort out its baseball analogue.)

Speaking of entrepreneurship, Schumpeter was the economist of the entrepreneur--we'll dwell more on this great thinker in the future. Here we'll simply note that Schumpeter placed a great deal of emphasis on "indeterminateness" in economic activity, a line of thought that is well covered in Thomas McCraw's recent biography of Schumpeter, Prophet of Innovation.

OK, so you get the point. Uncertainty rules in baseball and the economy because of the number of things that can affect possible outcomes. If a single play in baseball cannot be worked out or predicted in advance, how much harder is it for businesses and governments in their more complicated environments? This redounds back to the importance of rules, particularly those set forth by governments. Individuals and firms face enough uncertainty as it is--they don't need additional uncertainty created by arbitrary government action.

Perhaps we're consistently surprised by uncertainty because it often masquerades as certainty, or at least predictability, in the form of short-term patterns, for example. The course of a baseball season is often shaped by slumps and streaks. For apparently no reason, a player will suddenly lose the ability to get on base, or will go on a two-week tear. The same happens to teams, and we similar effects in the economy. Stock markets go through stretches of incredible gains or mounting losses; firms can stagnate for extended periods of time.

These short-term patterns can yield a small degree of predictability, and economic models allows us to predict with some confidence the short-term consequences of an action. Yet despite the fact that such patterns are regular economic phenomena and can have identifiable causes, one common trait is that they are usually unforeseen, and sometimes inexplicable.

But we're only human after all: we grasp for any measure of certainty in a world full of the dark matter of uncertainty. As we'll discuss in greater depth later, however, this uncertainty is what creates the opportunities exploited by entrepreneurs in the economic context and what we'll for now call "game-changers" in baseball. In short, uncertainty is a prime source of wealth creation and economic growth.

Or, as Lewis Lapham has written, paraphrasing an Arab proverb: "we have less reason to fear what might happen tomorrow than to beware of what happened yesterday." That's as true in baseball as in the economy.