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Expected utility theory vs.

prospect
theory: implications for strategic
decision makers.
By Sebora, Terrence C.
Publication: Journal of Managerial Issues
Date: Wednesday, March 22 1995

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 riskfocused 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. (See Schwenk (1984) and Barnes (1984) for
fuller discussions of the implications of decision biases for strategic decisions.)
The purpose of this paper is to extend the investigation of strategic decision
making and to suggest consideration of an alternative description of strategic choice
behavior. As Bell et al. (1988) indicate, more accurate descriptions of decision making
processes can facilitate better prescriptions for improving decision behavior. If utility
theory better describes strategic managers' decision behaviors, then prescriptions
designed to enhance the process may focus on engineering better choices (e.g.,
through education in the properties of utility theory and training in statistics). If
prospect theory better describes strategic decision behavior, however, then
prescriptions may favor techniques for compensating for framing consequences (e.g.,
frame structuring and improved feedback). Specifically, this paper reports the results
of laboratory tests designed to compare and contrast two models of individual
decision behavior, expected utility theory and prospect theory, in describing choice
behavior in strategic decision problems.
EXPECTED UTILITY THEORY AND PROSPECT THEORY
Expected utility theory suggests that choices are coherently and consistently
made by weighing outcomes (gains or losses) of actions (alternatives) by their
probabilities (with payoffs assumed to be independent of probabilities). The
alternative which has the maximum utility is selected (Einhorn and Hogarth, 1981).
Expected utility theory is based on three fundamental tenets about the processes that
occur during decisions made under risk and uncertainty: (1) consistency of
preferences for alternatives; (2) linearity in assigning of decision weights to
alternatives; and (3) judgment in reference to a fixed asset position (Kahneman and
Tversky, 1979). Based on these assumptions, expected utility theory predicts that the
better alternative will always be chosen (Kahneman and Tversky, 1984).

Expected utility theory does not allow for influences on choice due to
characteristics of the context of the decision. Prospect theory, on the other hand,
provides empirical evidence from "several classes of choice problems in which
preferences violate the axioms of expected utility theory" (Kahneman and Tversky,
1979: 263). Prospect theory indicates that, as Simon (1955) found, decision makers
prefer to simplify their choices cognitively whenever possible, satisficing rather than
maximizing. According to prospect theory, choice is a two-stage process. In its first
phase (framing), alternatives are edited and values are attached to outcomes and
weights to probabilities. In the second phase, similar to expected utility theory, the
edited alternatives are evaluated.
Prospect theory suggests decision makers exhibit three consistent violations of
the assumptions of utility theory in this two-staged process. First, they consider
choices as adjustments to their current wealth from a personal reference point. They
tend to be risk averse toward adjustments seen as gains, and risk seeking toward
adjustments seen as losses from this point. Second, decision makers tend to
overweight unlikely events and underweight likely events when assigning
probabilities, and they do not adequately distinguish between large numbers. Finally,
the manner in which alternatives are presented can influence the choices made (Bell et
al., 1988). Table 1 summarizes the differences in the utility and prospect theory
models of decision making highlighted in this study.
HYPOTHESES
Consistency in Preferences
Expected utility theory predicts a preference for dominant alternatives.
Alternatives which produce greater utility will always be chosen over those which
provide less utility. Decision makers are assumed to rank their preferences and discard
alternatives offering lower utility. In addition, expected utility theory predicts that the
choice is invariant, that is, the manner of presentation of the alternatives should not
influence the choice. Such a view assumes that decision makers seek to be aware of
multiple outcomes and are able to sift through the complexities of problems to
determine clearly a dominant prospect.
Prospect theory recognizes the information processing limits of human decision
makers and their tendency toward satisficing decision behavior. As such, it suggests
that decision makers often are not consistent in their preferences and are subject to
influence by the way alternatives are presented to them. Two aspects of bounded
rational behavior are seen to influence choice behavior. First, decision makers
simplify their choices to reduce cognitive effort. For example, choices that are
concurrent tend to be framed as separate choices by the decision maker to reduce
cognitive effort (Tversky and Kahneman, 1981). Second, these separate acts are then
processed sequentially. Because concurrent choices are simplified into separate acts
and processed sequentially, decision makers can overlook the possibility that the two
separate reasonable choices, when viewed concurrently, could result in a less than
maximizing choice. The alternative is also possible. The failure to deal with
concurrent choices can lead to a failure to see that two seemingly unreasonable
separate choices, when viewed concurrently, could produce a superior option. In

either case, the alternative producing the maximum payoff is not chosen, violating the
consistency of preference assumption of expected utility. This discussion leads to the
following hypothesis:
Table 1
Comparison of Utility and Prospect Theory Descriptions of Choice
Behavior(1)
Consistency of Preferences
Utility Theory
Prospect Theory
Decision maker preferences are
Due to complexity of choice
consistent (transivity), ordered
problems and decision makers'
(dominance), and context
limited information-processing
insensitive (invariance). That
ability, preferences are not
is, decision makers can rank
consistent. Dominated
their choices on the
alternatives are not always
attractiveness of each
discarded. Finally, both the
alternative, dominated
method of deciding and
alternatives can be eliminated,
presentation of the alternatives
and preference is not influenced
influence decision behavior.
by how the choice is required to
be made or how the alternatives
are presented to the decision
maker.
Linearity of Decision Weights
Utility Theory
Prospect Theory
Utility functions are subjective
Value functions are subjective
maps of the objective values of
maps of the values of possible
possible outcomes, where the
outcomes, where the shape of the
shape of the function reflects
function reflects the nature of
the nature of a decision maker's
a decision maker's attitude
attitude toward risk.
toward risk and where
probabilities attached to
outcomes are weighted with the
result that small probabilities
are overvalued and larger
probabilities are undervalued.
Reference Point
Utility Theory
Prospect Theory
Decision makers make choices
Decision makers make choices as
based on the change in final
deviations from a current
value of the outcomes of their
gain/loss reference or point.
choices, not on whether the
Relative to this reference point,
change is a gain or a loss.
decision makers are more sensitive
to losses than they are to gains.
1 This Table is based on the comparison between utility and prospect

theory found in Hogarth (1987:87-111).


H1: When making strategic choices, decision makers are influenced by
presentation factors and do not always choose the alternative with the maximum
payoff.
Linearity of Decision Weights
The second tenet of expected utility theory holds that decision weights used to
value alternatives are linear. In utility theory, the value of an alternative is determined
by weighting the utilities of possible outcomes by the probability of their occurrence.
The best alternative is the one which provides the highest payoff (e.g., a 1% chance of
winning $1000 is better than a 99% chance to win $10). The decision maker is
assumed to select the alternative with the highest utility.
Alternatively, in violation of the decision weights assumption of expected utility,
prospect theory suggests that decision weights are neither linear nor value free.
According to prospect theory, people give unlikely events more weight than they
deserve and assume highly probable events to be certainties. In addition, there is a
strong certainty effect; if subjects are pleased with an outcome that they perceive as
certain, they prefer it to an alternative that requires a gamble for a higher payoff. This
leads to the following hypothesis concerning decision weights:
H2: When making strategic choices, decision makers do not always choose that
alternative that results in the highest utility, as determined by multiplying expected
outcomes by their probabilities.
Decision Reference
Under the assumptions of utility theory, the outcomes to which probabilities are
assigned are considered to be fixed states of wealth. This approach implies that
preferences reflect a comprehensive understanding of the decision makers' options.
Evaluation of alternatives is made from a single, unchanging reference point that is
based on this comprehensive understanding of different states of wealth. Utility theory
predicts that the value choice is made from a point in reference to the total asset
position of the decision maker. Because the asset base remains constant, the reference
point is neutral and the evaluation is linear. As such, in choosing among alternatives
decision makers do not consider the consequences of multiple transactions among
choices or trades among the alternatives. Finally, this preference is expected to
demonstrate risk aversion (i.e., preference for a certain alternative over a risky
alternative of equal value).
In violation of the risk preference assumptions of expected utility, prospect
theory indicates that decisions are made by considering the change (gain or loss) that
each choice outcome will produce in the decision maker's current wealth. In addition,
prospect theory indicates that people have a tendency to view outcomes from a
reference point. They are risk averse above this reference (i.e., in choices involving
gains), while at the same time being risk seeking below it (i.e., in choices involving
losses). Responses to losses are more intense that those to gains (Kahneman and
Tversky, 1979; Hershey and Schoemaker, 1980). This leads to the following
hypothesis concerning decision reference:

H3: When making strategic choices, decision makers are risk averse when
making decisions among alternatives that result in gains (i.e., choosing certain
outcomes with lower payoffs over probable outcomes with higher payoffs) and risk
seeking when making decisions among alternatives that result in losses (i.e., choosing
probable outcomes with lower payoffs over certain outcomes with higher payoffs).
Decision Reversal
Finally, based on the prediction of expected utility theory, decision makers are
not susceptible to preference reversal. Regardless of the context in which the decision
problem is presented, decision makers always make the maximizing selection.
According to Kahneman and Tversky (1982), a reversal of preferences can be induced
by altering the description of decision task. According to these authors, a reversal of
preferences occurs "when the same objective alternatives are evaluated in relation to
different points of reference" (1982: 166). Preference reversals are possible because of
violations of preference, linearity, and reference assumptions. In violation of the
combined assumptions of utility theory but consistent with the tenets of prospect
theory as discussed above, the following hypothesis on preference reversal is
suggested:
H4: When making strategic decisions, decision makers, subject to the form in
which their alternatives are framed, do not always choose the alternative that provides
maximum utility for their firms.
METHOD
Subjects
The sample was composed of a group of 307 university students enrolled in
undergraduate and graduate classes in Business Policy and Strategy at a Midwestern
State University. Participation was voluntary. All subjects were past mid-term in a
capstone course in business strategy in their final semester of studies. Subjects were
randomly assigned one of two experimental conditions.
Procedures
Each subject was provided with a set of four decision problems. The problems
were based on problems used by Kahneman and Tversky (1979, 1982, 1984) and
adapted to reflect typical strategic issues. The adaptations were derived from actual
case studies found in a business strategy text (Pearch and Robinson, 1985). Strategic
management is concerned with improving firm performance by finding answers to
two fundamental questions: "Where should a firm compete?" (corporate strategy) and
"How should a firm compete?" (business strategy). The Bendix/Martin Marietta case
involves a typical corporate strategy, problem while the Georgia-Pacific case presents
a typical business strategy problem. The third problem involves the cost of strategic
decision making aids. We believe the use of a case context extends previous research
on prospect theory and is consistent with strategic decision making processes.
While none of the students had studied these specific cases, all were familiar
with the case analysis process and had analyzed other cases concerned with strategic
choices. The problems were designed to determine whether utility theory would
describe the outcomes of decisions concerning strategic choice. Each set consisted of
one half of a matched pair of problems. One half of the pair was structured to provide

an expected utility, theory, base line for the choice preferences of this sample. The
other was structured to prospect theory preferences. The actual problems provided to
the subjects included case context information and were longer and more detailed than
the comparative questions included in this paper. Each questionnaire included the
following instructions: "For each of the problems below, you are asked to make a
strategic business decision. Read the background information carefully. Then,
following the instructions for the problem, select the answer option you prefer."
Paired problems 1&2 and 3&4 focused on editing and problems 5&6 and 7&8
focused on problem structuring influences on preferences. Each of the first three sets
of problems (1&2, 3&4, 5&6) was designed to test one of three tenets of utility
theory. For each set, the strategic issue questions were based on information found in
strategy case studies. The final problem set (7&8) was designed to test the preference
reversal phenomenon in a more complicated strategic choice problem. This problem
set used an entire case study as the basis for our subjects' decision. The paragraphs
provided in the tables below for questions 2, 3, 7, and 8 are summary statements
added to the end of the case. It is important to recognize that, although these
summaries appear to contain different facts, all information in both summaries was
contained in the case presentation. The summaries merely highlighted one or the other
set of previously presented facts.
The choice patterns of this sample were analyzed according to the subjects' level
of theoretical training, undergraduate (UGRAD) or graduate (GRAD), and their
experience in managerial decision making. The second variable categorized the
amount of management experience as follows: 1) subjects who had not held jobs
requiring management decisions or had less than one year's management experience
(ME = 0), and 2) subjects who had held management positions for at least one year
(ME[greater than]0).
The Study's Design
It should be recognized that this study exhibits many of the same limitations
recognized by Kahneman and Tversky (1979) in their initial presentation of prospect
theory. This study relies on hypothetical strategic choices by students asked to act as
strategic managers in a laboratory setting. It also assumes that students of strategy
reflect the decision processes used by top managers to make strategic decisions. These
conditions, of course, raise questions about the validity of method and generalizability
of results. In spite of possible limitations, students were used in this study for three
reasons: 1) past practice, 2) evidence of similarity of choice behavior between
students and practicing managers, and 3) evidence that students, when they differ
from practicing managers, provide a more conservative test of the phenomenon. Each
is discussed in turn.
The use of students to investigate strategic and behavioral decision processes in
laboratory, settings has been and remains an accepted methodological procedure (for
example, see Kahneman and Tversky, 1979; Schweiger et al., 1986; Bukszar and
Connolly, 1988). Student subjects are generally considered appropriate in this
research based on the assumptions that people often know how they would behave in
actual situations of choice, and that they have no special reason to disguise their true

preferences. The sample of more than 300 students also offers a wide cross section of
decision makers from a variety of backgrounds. In addition, Kahneman and Tversky
(1979) point out that no method is without flaws when investigating utility theory and
argue that studies of this kind should be evaluated on their contribution. The basic
question for this study centers on whether the decision behaviors described by
prospect theory can be extended to strategic choice problems. Emphasis is placed,
therefore, on construct validity associated with prospect theory and the nature of the
problem. Field settings could not provide control over either and, hence, their validity
could be questioned. Following the advice of Campbell (1986), we chose a setting and
design which we feel best allows us to answer our basic question.
Second, there is evidence that students do behave similarly to practicing
managers when executing strategic decisions. Bateman and Zeithaml (1989), for
example, tested framing effects in a strategic reinvestment decision. In their
experimental test of framing and strategic decision making, these authors
demonstrated that there were no significant differences in the strategic decisions made
by practicing managers and student subjects.
Third, while the possible limitations of the use of students as subjects have been
recognized, there are occasions in which their use may not limit external validity
significantly even when they may behave differently than practicing managers
(Greenberg, 1987). We believe that characteristics of the subjects used in this study
are one of those occasions. All of our subjects were either second semester seniors or
final year graduate students who were at the end of a formal presentation of business
policy and strategy course. Fredrickson (1985) found that such students may make
decisions different than practicing managers. The use of students, however, results in
a more conservative test of prospect theory. Students are in school using word
problems and are recently trained in and tested on the use of statistics and in making
operations, investment, and marketing decisions. Therefore, these students were more
apt to apply expected utility models to word problems, to look for "trick" questions,
and to not get distracted or confused by the complexity of the situation. As
Fredrickson found, if students are different in their decision processing, it tends to be
in ways that are likely to reduce actual framing effects rather than increase them.
RESULTS
Problems 1 and 2 investigated expected utility theory, assumptions related to the
alternatives from which one must select. To test these tenets of utility theory, the two
groups were provided with one of the problems reported in Table 2. Problem 1 was
constructed as a simple and transparent choice to provide a baseline for the preference
consistency associated with the maximization assumption of expected utility theory
(see Kahneman and Tversky, 1984). Expected utility theory predicts that 100% of
subjects would select option B in Problem 1. The percentage choosing each option is
indicated in parentheses after each choice.(1)
Problem 2, designed to test preference consistency, was drawn from a textbook
case study (Pearce and Robinson, 1985) involving an acquisition decision. While the
decision context was strategic, the values and probabilities associated with each
alternative in the basic choice remained the same as in Problem 1. In Problem 2,

expected utility theory would predict a unanimous preference for the BC choice
combination (the equivalent of choice B in Problem 1). In decision (i), B, the riskier
alternative, clearly dominates A ($250 [greater than] $240). In decision (ii) risk
aversion would indicate a preference for certain alternative C over riskier alternative
D.
The results indicate (see Tables 2 and 3) that, overall, the most preferred choice
pattern was AD (45%), while the clearly superior pattern (BC) was preferred by only
12% of the respondents.(2) The payoffs for choice combination AC were exactly
equivalent to choice A in Problem 1 and equalled a loss of $510. The payoffs for
choice combination BC were exactly equivalent to choice B in Problem 1 and
equalled a smaller loss of $500. Contrary to the predictions of utility theory, a
significant portion of the subjects chose a set of acts which, when combined, produce
a less than maximum outcome. When these same choices were presented in their
combined form in Problem 1, the respondents chose the dominant option. The results
were reversed when the choice between acts were presented as a set of distinct yet
concurrent options (as may be typical of strategic decisions), even though the
instructions for Problem 2 pointed out the complexity of the problem and the
computations were kept simple.
Table 3 displays the respondents' responses and the results of chi square analysis
for the various comparisons used in this study. Chi square results indicate that the
subjects' choice preferences differed significantly overall and within each category
from the outcomes predicted by utility theory. Hypothesis 1 is supported. Risk
preference differences for gains and losses was found significantly different overall
and for subgroupings (i.e., UGRAD, GRAD, ME = 0, and ME[greater than]0
categories). In addition, examination of the preference between the choices in
Problem 1 and Problem 2 indicates a significant reversal between the two problems in
preferences overall and across all categories. This reversal is contrary to expected
utility and consistent with the predictions of prospect theory.
The choice of combination AD (i.e., a 25% chance to gain $240 million and a
75% to lose $760 million) over BC (i.e., a 25% chance to gain $250 million and a
75% chance to lose $750 million) is consistent with previous findings of prospect
theory (Kahneman and Tversky, 1979), as indicated in Table 1. Our subjects
apparently framed Problem 2 as a pair of distinct choices rather than concurrent
choice. The choice of A over B in decision (i) indicates a preference for a certain
lesser gain (a risk-less prospect) over a probable greater gain (a risky prospect of
greater expected value), and is contrary to the dominance assumption of expected
utility theory. The choice of D to C in decision (ii), indicating a preference for a risky
(and possibly greater) probable loss over a certain loss, represents a reversal
consistent with prospect theory and is contrary to expected utility theory. The net
result of these two choices is a preference for AD over BC, a choice for a riskier,
inferior option. Such a preference reversal supports the hypothesis that strategic
decisions can be influenced by the manner in which decision data are presented to the
decision maker, leading to choices that are contrary to the dominant expected
outcome.

The second tenet of expected utility theory holds that the utility of a choice is
determined by weighting outcomes by the probability of occurrence with the
consequent weighted outcomes being equal to the decision maker. Expected utility
theory would predict no preference between a 25% probability of winning $100 and a
50% chance of winning $50. To test this probability weighting, the subjects were
presented with one of the two problems found in Table 4 and derived from the same
case cited above.
The probability weighting property of expected utility theory would predict that
all respondents should prefer choice B in both Problems 3 and 4, as its weighted value
in each case ($72 and $18) is clearly superior to each A option ($60 and $15). In
Problem 3, however, 44% of the respondents selected choice A and 25% of the
respondents chose A in Problem 4. Hypothesis 2 is supported. Both choices were
contrary to the predictions of utility theory, suggesting, consistent with the findings of
Kahneman and Tversky (1984), that neither the utility value nor the probability
weighting are linear.
Table 2
Problem Statements and Response Patterns And Chi Square Tests for
Problems 1 and 2
Problem 1 (N = 153): Choose between:
A. 25% chance to win $240 and 75% chance to lose $760
(7%)
B. 25% chance to win $250 and 75% chance to lose $750
(93%)
Problem 2 (N = 153): Imagine that you are the president of Bendix
Corporation. You must decide whether your firm should acquire
Martin Marietta. If you make a bid for the company, you will be
faced with the following pair of concurrent decisions (due to
the fact that it is rumored you may be a target for acquisition
by another firm). You should examine both decisions, then indicate
the options you prefer, remembering that these decisions are being
made at the same point in time.
Decision (i) Choose between
A. a sure increase of $240 million in Bendix's value
(52%)
B. 25% chance to increase Bendix's value by $1
billion and 75% chance to gain nothing
(48%)
Decision (ii) Choose between
C. a sure loss of $750 million in Bendix's value
(19%)
D. 75% chance to lose $1 billion in Bendix's value
and 25% chance to stay as you presently are
(81%)
Problem 1 Response Pattern:
Problem 2 Response Pattern:
Variable
N
A
B
AC
AD(1)
BC(2)
BD
OVERALL
153 11
142
11
69
18
55
UGRAD
116 10
106
7
55
12
42
GRAD
37
1
36
4
15
6
12
ME = 0
88
9
79
4
46
8
30
ME [greater than] 0
65
2
63
7
25
9
24

1 Paired choice AD is the exact equivalent of A in Problem 1.


2 Paired choice BC is the exact equivalent of B in Problem 1.
[TABULAR DATA FOR TABLE 3 OMITTED]
[TABULAR DATA FOR TABLE 4 OMITTED]

The certainty preference was most apparent in Problem 3 where the actual choice
was sequenced as a series of two choices with the second dependent upon the
outcome of the first. According to the problem statement there is only a 25% chance
that a bid will be made. Subjects appear to have disregarded the conditional nature of
the choice and that disregard made the "certain" outcome more attractive than the
higher but "less certain" outcome.
Table 4 presents the results of the analyses testing Hypothesis 2. Chi square tests
indicate a significant difference in the choice pattern between Problem 3 (in which
options were sequenced) and Problem 4 overall and in each category. (Chi square tests
could not be computed for the difference between the choice patterns of the subjects
and the prediction of utility theory because it predicts a 100% selection of one option.
This creates a zero value in one cell.) Chi square tests also indicated a significant
reversal in the decision choice pattern between problem 3 and 4 overall and in the
UGRAD and ME = 0 categories. These results indicate that subjects were influenced
by the sequencing of Problem 3 to reverse their decision patterns.
The subjects did not merely multiply an expected outcome by its probability of
occurrence and selected the maximum outcome. They were apparently influenced by
their perception of the certainty of the occurrence, preferring more to less certainty,
and were willing to accept what they expected to be more certain but smaller
outcomes. Contrary to utility theory they did not seem to view the values of their
choices or the probabilities of their occurrence as linear as indicated in Table 1.
As discussed above, utility theory would predict that the value choice is made
from a point in reference to the total asset position of the decision maker and gains or
losses are measured by their addition to or subtraction from that asset base. Because
the asset base remains constant, the reference point is neutral and the evaluation is
linear. Prospect theory suggests that decisions can be made on the basis of this
"general account" reference or on a "minimal account" reference. To test the asset
reference tenet indicated in Table 1, subjects answered one of the questions found in
Table 5.
The first question implied a value of $10,000 to the consultant's information.
Payment of that amount and failure to secure the information would mean a new value
of $20,000 for the information. In the second question the value of the information
remained constant, although the asset position of the firm was affected in the same
magnitude as in the first choice option. Our chi square results indicated the subjects'
choice pattern was significantly different than a 50-50 choice pattern. Utility, theory,
however, would predict that the choice pattern for both problems remain constant
because the effect on the asset base was the same in both instances.
Hypothesis 3 is not supported. As presented in Table 5, chi square results indicate
no significant difference in choice patterns overall or for UGRAD, GRAD, and

ME[greater than]0 individual variables. This suggests that these decisions were
apparently made consistently in reference to the overall asset position of the firm.
Presentation context did not influence a change in reference point. Given the
magnitude of the dollar amounts in previous questions, the subjects may have
assumed a broad asset base and measured [TABULAR DATA FOR TABLE 5
OMITTED] the losses against that presumed base. The loss of $10,000 was not
measured against the value of advice but against the more general asset account of the
firm. This finding, however, is tempered by the reversal found in respondents with no
managerial experience. Here, preference reversal was indicated, suggesting that
experience may moderate the asset reference effect.
Given the violations of the assumptions of expected utility theory evident in the
preceding results, the problems found in Table 6 were used to examine the presence
and consequence of the framing effect predicted by Kahneman and Tversky (1979).
The background information on a company and a proposed product introduction were
presented in two versions of a short case. The information was again taken from a
standard textbook case study (Pearce and Robinson, 1985). The basic information was
identical in each of the decision frames. The summary paragraphs presented in Table 6
were included at the end of the case. The concluding paragraph in each case
presentation was designed to accentuate certain portions of the case information in
order to present that information as loss (7) or gain (8) and uncertain (7) or certain (8).
Expected utility theory would indicate that such framing should not impact the final
decision.
Table 6 presents the results of analysis of questions used to test Hypothesis 4.
Based on these results, Hypothesis 4 is supported. Chi square results indicate that the
subjects did, in fact, reverse their decision patterns overall and in each of the
variables. These results again support the fact that expected utility theory does not
appear to describe strategic choice outcomes. Prospect theory may serve as a better
representation of preference in strategic choice under conditions of uncertainty and a
better foundation for prescriptive theories of strategic choice.
Expected utility theory has been assumed to provide the strongest base for
informing managers about decisions made under conditions of uncertainty. The
purpose of this study was to test whether that assumption was supported in a strategic
decision-making context. The results indicate that choices were made that produced
less than maximum quantitative utility, contrary to the assumptions of utility theory.
The decision patterns appear more consistent with the tenets of prospect theory as
outlined in Table 1.
In their responses to Problems 1 and 2, our subjects made decisions consistent
with those found by Tversky and Kahneman (1981). They exhibited a stronger
preference for risk toward losses than toward gains. In addition, when faced with a
decision that is contingent upon another prior decision with only probable outcomes,
our subjects apparently ignored the probability of the prior decision and viewed its
outcome as certain data for the second decision, resulting in a less than maximum
outcome (as exhibited in the responses to Problems 3 and 4). Finally, preference
reversal is found between Problems 1 and 2, between Problems 3 and 4, and between

Problems 7 and 8, apparently supporting the violations described by prospect theory


(Kahneman and Tversky, 1979, 1984).
IMPLICATIONS FOR STRATEGIC MANAGERS
This study provides empirical support for the hypothesis that managers
[TABULAR DATA FOR TABLE 6 OMITTED] are subject to framing effects when
making strategic decisions. They are subject to making bold forecasts but timid
choices (Kahneman and Lovallo, 1994). Managers do not always choose the dominant
strategic alternative. As such, this research extends prospect theory implications into
another dimension of business decisions. In addition, it furthers the development of a
better descriptive model of individual strategic decision making and supports the call
for research that will help managers offset the negative effects of decision framing.
The relative infrequency of the decision, the idiosyncratic, nonroutine, and
unstructured nature of strategic problems, and the gap between the time of the
decision and the evaluation of the outcome suggest that strategic decision makers may
be even more prone to the effects of decision framing. Hogarth (1987) and Russo and
Schoemaker (1989) argue that education about and training in utility theory do not
eliminate decision framing characteristics in typical decisions but these authors
indicate the effects of framing can be compensated for. If strategic managers are to
improve their choice behaviors, it is important that they begin to recognize where
framing effects can occur and what consequences these effects might have. As
Hogarth states, awareness of framing effects and the ability to exploit them "could
well lead to competitive advantages" (1987: 105). The results of this study suggest
that future research could benefit managers by identifying methods through which
framing could provide such advantages.
Most of the time strategists are concerned with pursuing a current strategy as
effectively as possible. Prospect theory indicates two cautions in this area. First,
assuming that the strategy, is pursued because it is successful, decisions will reflect
risk aversion and, perhaps, the failure to recognize riskier and potentially greater
gains. In managing stability, managers should still recognize that they have more
opportunities than resources and that those opportunities shift. When things are going
well, prospect theory indicates, and the results of this study support, that decision
makers often see change as a "loss." As such, there is a tendency to be risk seeking to
avoid this loss. Strategic managers should be alert to the fact that, if they feel that they
need to take risks to stay the same, they may be making unacceptable choices. Smaller
risks should be associated with sustaining continuity and larger with instituting
change.
Second, top managers tend to be overconfident, believing that they are better at
assessing risk (Russo and Schoemaker, 1989). In addition, the intimate knowledge of
their firms that good strategic managers have can lead to an inappropriate reliance on
intuition (Hogarth, 1987). Reliance on intuition, coupled with over-confidence, may
lead to an approach to making strategic decisions in which low probability/big gain
opportunities are undervalued, low probability/big loss situations are overvalued, and
high probability outcomes are seen as "sure things." As a consequence strategic
managers may miss important early discontinuities (i.e., potential gains) or invest

significant resources to insure themselves against overweighted unlikely outcomes.


The best match is still a consequence of calibration of probable outcomes with their
payoffs. This calibration should be based on accurate record keeping rather than
reliance on memory and intuition (Hogarth, 1987). Future research, testing the effects
of intuition and calibration methods, could assist managers in identifying the
occasions in which their intuition may or may not be appropriate for strategic
decisions.
Strategic management also requires decision makers to detect changes that could
affect their firms in the future. Prospect theory indicates that managers are not very
good at this. As McCall and Kaplan (1990) note, choices do not always come when,
where, or how managers expect them to be. Russo and Schoemaker (1989) indicate
that framing affects both the recognition and response to problems by providing the
boundaries (what will be considered part of the choice set), reference points (elements
used to determine success and failure), and yardsticks (how the outcomes are
measured). These authors suggest considering each strategic problem from multiple
frames. Expanding the boundaries, investigating various reference points, and
measuring with different yardsticks can help to illuminate a manager's current frame
and to help to reframe decision. In addition, Hogarth (1987) recommends that
decision makers cultivate a tolerance for ambiguity ("Stuff happens!") and an
acceptance of surprise ("I didn't know that!") as prerequisites to making judgments
and executing choices. Because managers tend to avoid ambiguity and surprise, future
research may be needed to convince them of the benefits of both for effective strategic
decision making.
While the fundamental purpose of any business strategy is related to maximizing
wealth, now that wealth is measured and what determines "maximum" are both
influenced by the context of the strategic problem. Prospect theory, supported in the
results of this research, suggests that the context in which the strategic problem is
understood influences how the outcomes of the strategic effort may be framed.
Differences in outcome frames, in turn, affect the process by which alternatives are
initially addressed and simplified. Strategies associated with gains (e.g., shareincreasing, growth, profit, acquisition) may lead to different processes than those
linked to losses (e.g., asset reduction, turnaround, endgame, divestiture). In fact,
different contexts can lead to significant shifts in the preferences strategists may have
for certain actions. In addition, because decision behaviors linked to gains (e.g.,
increased risk aversion) have been demonstrated to be different than those linked to
losses (e.g., increased risk seeking), even when the outcomes in dollar values for both
are identical, strategists may not take full advantage of gain-related strategies while
overcommitting resources to avoid losses. When faced with a need for action,
strategists should be careful to consider the context of their choices in ways that
highlight both the expected gains and losses.
1 As can be seen in Table 2, 7% of our subjects selected a clearly inferior option.
There are at least three possible explanations for this choice of option A: 1)
computational error, 2) misreading of the question, or 3) purposeful
misrepresentation. Because the subjects were students, the third explanation may be

most likely. We felt, however, that retention of this pattern (A = 7%; B = 93%) was
warranted because it provided a more conservative base for testing the invariance of
this choice pattern in problem 2, which structured the same data differently. In
addition, if some students misrepresented their true preferences in both forms of the
question, random assignment suggests that retention of this pattern from Problem 1
should compensate for misrepresentations in Problem 2.
2 It should be noted that the problem sets offered the subjects no comparable
options for combinations AC or BD. Using only the exactly comparable pairs again
offers a more conservative test of the effect. As computation indicates, choices
involving A provided less favorable outcomes than those involving B.
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