Academic journal article
By Paulson, Steven K.
Academy of Strategic Management Journal , Vol. 8
The assumption of rationality in economics has been challenged most recently by prospect theory. Prospect theory has claims that an individual's personal position relative to a good or service will determine the value of that good to the person in addition to the individual's position relative to the general market for the good (cf. Kahneman, 1999; List, 2003a; List, 2003b; Thaler, 1980). Similar ideas have been discussed as "fuzzy-set social science" (Ragin, 2000; Sen, 2002; Baliamoune, 2003). In the related field of organizational theory, Zey (1998) has argued that rational choice theory is inadequate as a basis for describing and explaining reality; she argues for an historical political economy contingency perspective. The same underlying conceptual themes appear in the work of Miles and Snow (1994) who discuss the "prospecting" strategy.
In this paper, the conceptual relationships between prospect theory as developed and applied to the field of economics by Kahneman and Tversky (2000a, 2000b), Kahneman and Lovallo (1994) and Tversky and Kahneman (2000, 1981) and prospect theory as developed and applied by Miles and Snow (1994, 1978) are discussed. The paper concludes that there is a clear convergence of these theoretical perspectives and that future empirical and macro theoretical integrative work is necessary.
TWO PROSPECT THEORIES
In this section, two theoretical statements will be described, their similarities will be presented and the argument will be presented that because of these similarities, "prospect theory" has far greater applications than envisioned by their respective proponents. The first of these theories is the "prospect theory" developed by economist Daniel Kahneman and various collaborators and stands in contradiction to standard expected utility theory. Expected utility theory underlies much of the reasoning of contemporary economic theory. The second is the "prospect theory" developed by the organization management theorists Raymond Miles and Charles Snow and various collaborators and stands in contradiction to standard rational contingency theory. Rational contingency theory underlies much of the reasoning of contemporary organizational theory.
Economic Prospect Theory
Economic prospect theory was created, essentially, because of apparent weaknesses in the conventional wisdom of classical economic theory. As Edwards (1996) describes:
Prospect theory was formulated... as an alternative method of explaining choices made by individuals under conditions of risk. It was designed, in essence, as a substitute for expected utility theory [because the] expected utility theory model did not fully describe the manner in which individuals make decisions in risky situations and that therefore, there were instances in which a decision-maker's choice could not be predicted. For example, they point out that expected utility theory does not explain the manner in which framing can change the decision of the individual, nor does it explain why individuals exhibit risk-seeking behavior in some instances and risk-averse behavior in others. (Edwards, 1996)
Essentially, then, economic prospect theory attempts to demonstrate that a major flaw of expected utility theory is that it assumes that people assign values to final outcomes and make choices on the basis of them. An example of this assumption is the use of the conventional "present value" formulation to estimate the final value of assets as a crucial element in assessing the desirability of alternative courses of action. Prospect theorists, however, assume that people differentially evaluate gains and losses and not expected outcomes or goal states. They demonstrate, for example, that people value "probable" outcomes differently than they do "certain" outcomes; when outcomes are more probable people will exhibit more risky behavior than when outcomes are less risky. That is, the domain of the utility function for expected utility theory is final states rather than gains or losses per se! …