A Prospect Theory Model of Resource Allocation

Abstract

Many papers in organization theory and strategy use prospect theory, but few derive their hypotheses from prospect theory's formal model. This paper develops a prospect theory model of resource allocation under risk where projects have both positive and negative adjusted payoffs. The model assumes consistent value (rather than profit) maximizing behavior and demonstrates how resources, risk propensity, and reference levels interact to determine allocations to risky projects. The analysis shows that prospect theory's parameters interact in complex ways to influence risk taking, which makes simple predictions difficult. Overall, loss aversion and the reference point dominate the results, with curvature of the value function playing a secondary role and the maximum risk aversion occurring for firms near their reference points, not for firms above their reference points.

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