Academic journal article Journal of Managerial Issues

Expected Utility Theory vs. Prospect Theory: Implications for Strategic Decision Makers

Academic journal article Journal of Managerial Issues

Expected Utility Theory vs. Prospect Theory: Implications for Strategic Decision Makers

Article excerpt

According to Bourgeois, strategic choice means that "the top management or dominant coalition always retains a certain amount of discretion to choose courses of action that serve to coalign the organization's resources with its environmental opportunities and to serve the values and preferences of management" (1984: 591). Indeed, it is suggested that organizations are reflections of their top managers (Hambrick and Mason, 1984) and the choices they make (Chaganti and Sambharya, 1987). Researchers in strategic management have begun to investigate strategic decision making at the individual level of analysis, asking whether or not the way top managers actually make decisions affects organizational performance. The orthodox approach for the treatment of decision making has been to rely on normative models of choice. Bell et al. (1988) indicate that the most commonly employed model is expected utility theory.

Recent research in the area of individual decision behavior and strategic decisions, however, has indicated that top managers do not always behave according to the assumptions of utility theory. That is, they do not seek to know all possible outcomes, always assign accurate probabilities to the outcomes they recognize, or consistently select the best payoff from considered alternatives (Isenberg, 1989). Furthermore, March and Shapira (1987) conclude that general managers typically fail to follow the canons of decision theory and that the ways they think about risk do not fit into classical conceptions of risk associated with utility theory.

These findings may be seen as part of a growing investigation of better descriptive models of top management decision making and interest in the influence of what has been termed "decision framing" by Kahneman and Tversky (1979). Decision framing and its implications were initially investigated in a variety of risk-focused decision contexts (e.g., environmental issues (Slovic et al., 1979), civil defense (Fischhoff, 1983), risk and insurance (Hershey and Schoemaker, 1980), bargaining (Neale and Bazerman, 1985), resource allocation (Northcraft and Neale, 1986), escalation of commitment (Schaubroeck and Davis, 1994), and even politics (Jervis, 1992)). Research on framing in business contexts has primarily investigated decisions associated with marketing (e.g., Mowen and Mowen, 1991; Kalwani et al., 1990; Qualls and Puto, 1989; Casey, 1994) and finance (e.g., Garland and Newport, 1991; Whyte, 1993).

While Duhaime and Schwenk (1985) advocated the examination of the influence of framing on strategic decision making in both laboratory and field settings, the impact of framing on strategic decision making has only begun to be systematically investigated. Fredrickson (1985) and Dutton and Jackson (1987) respectively indicate that top managers' decision behavior is influenced by the motive (e.g., problem or opportunity) and the category (threat or opportunity) present at the beginning of the decision process. And, Bateman and Zeithaml (1989) find that framing of strategic alternatives does influence choice outcomes. In addition, Schwenk (1984, 1986) and Barnes (1984) report the use and consequences of decision biases such as availability, selective perception, representativeness, and illusion of control on strategic decision making.

Decision biases affect the way decision makers acquire, process, and evaluate information on which they base their choices (Hogarth, 1987). Availability and selective perception biases, for example, suggest that decision makers will define problems in terms of what is most easily recalled from memory and/or most consistent with what is already known. Similarly, research on representativeness and illusion of control biases indicates that decision makers can be insensitive to the fact that they are making decisions based on small samples and are often overconfident in their true predictive abilities. In both cases the risks and consequences of strategic alternatives are inaccurately valued. …

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