Holmes Et Al. (2011) - Management Theory Applications of Prospect Theory - Accomplishments, Challenges, and Opportunities.

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Management Theory Applications of Prospect Theory: Accomplishments,

Challenges, and Opportunities
R. Michael Holmes, Jr, Philip Bromiley, Cynthia E. Devers, Tim R. Holcomb and Jean B.
McGuire
Journal of Management 2011 37: 1069 originally published online 7 February 2011
DOI: 10.1177/0149206310394863
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Management Theory Applications of Prospect

Theory: Accomplishments, Challenges,
and Opportunities
R. Michael Holmes Jr.
Florida State University
Philip Bromiley
University of California, Irvine
Cynthia E. Devers
Tulane University
Tim R. Holcomb
Florida State University
Jean B. McGuire
Louisiana State University
The authors review management research drawing on prospect theory, focusing primarily on
studies in strategic management and organizational behavior/human resource management.
These studies have made valuable contributions to several prominent research streams.
However, they commonly underutilize or misconstrue central arguments from prospect theory.
Furthermore, they illustrate that applying prospect theory in organizational settings poses sev-
eral theoretical and methodological challenges. Thus, the authors review these studies, criti-
cally analyze them, and make suggestions to enrich future work.
Acknowledgments: We would like to thank Rhett Brymer, Mario Krenn, Eric Liguori, and Jennifer Sexton for their
feedback on earlier drafts of this article.
Corresponding author: R. Michael Holmes Jr., Florida State University, College of Business, Department of
Management, 821 Academic Way, P.O. Box 3061110, Tallahassee, FL 32306-1110, USA
E-mail: mholmes@cob.fsu.edu
1069
1070 Journal of Management / July 2011
Keywords: prospect theory; risk taking; reference points; value function; probability weighting
function; loss aversion; diminishing sensitivity; decision weights; framing
Scholars have studied individuals’ risk-taking decisions for centuries (Edwards, 1954).
Many research questions in the social sciences involve such decisions. For example, risk is
relevant to decisions as diverse as whom to marry, whether to select red or black at the
roulette table, when a country should go to war, and how much insurance to buy. Historically,
scholars relied heavily on normative models (e.g., expected value and expected utility theory)
to explain both (a) the decisions individuals should make and (b) the decisions individuals
actually make (Einhorn & Hogarth, 1981).
Departing from the normative approach, Kahneman and Tversky (1979) offered a highly
influential descriptive model of decision making under risk. This model, termed prospect
theory (PT), explained findings from laboratory studies that documented how individuals’
risk-taking decisions depart from the predictions of normative models. The elegance and
apparent simplicity of PT led to its widespread adoption by scholars in many fields, includ-
ing management. Indeed, more than 500 articles in leading management journals have cited
Kahneman and Tversky (1979).1
We review management research drawing on PT, focusing specifically on studies in stra-
tegic management and organizational behavior/human resource (OB/HR) management. In
addition to discussing the contributions of this work, we raise four areas of concern. First,
most of these studies use only one or two of the constructs and arguments that compose PT,
and few studies use it as a coherent whole. Second, many studies claiming to draw on PT
make predictions inconsistent with it (Bromiley, 2010). Third, scholars implement PT in
disparate ways, limiting comparability across studies. Fourth, scholars often use PT, which
is an individual-level theory, to explain higher-level phenomena, but the extent to which PT
translates theoretically and empirically to higher levels of analysis is open to debate. Given
these concerns, we conclude that despite decades of management research drawing on PT,
(a) its past contributions to our field remain unclear and (b) a continuation of extant practices
would limit its potential to contribute in the future. As such, we encourage scholars to pursue
new questions and revisit old ones by using PT more precisely and comprehensively.
We begin by describing PT in detail. Specifically, we place PT in its historical context
by outlining the basis of much decision-making research prior to its development. In addi-
tion, we explain the individual constructs and arguments embedded in its two central
components: the value function and the probability weighting function. We also discuss
how PT differs from two other important theories that explain decision making under risk,
expected utility theory and the behavioral theory of the firm (BTOF), thereby highlighting
PT’s distinctiveness.
We next review management research drawing on PT. First, we describe how we selected
studies to review. The studies coalesced around key research streams, which we organize by
level of analysis. At the individual level, we review research drawing on PT to examine
executive compensation, negotiations, affect and motivation, and human resource manage-
ment (HRM). At higher levels of aggregation, we review research using PT to explain rela-
tions between organizational risk and return, as well as the antecedents and consequences of
firms’ risk-taking behaviors.
Holmes et al. / Management Theory Applications of Prospect Theory 1071
From this base, we analyze extant use of PT in the management literature and offer
suggestions to improve future research. We illustrate that scholars must utilize PT in its
entirety to derive accurate predictions consistent with the theory (Wakker, 2003). We also
discuss the many challenges that arise when scholars attempt to apply concepts from PT to
the complex multilevel context of organizations. In doing so, we question whether PT
definitively explains the findings of many management studies that have used it. In light of
these concerns, we urge scholars to derive their hypotheses directly from PT’s two central
components. By extension, they should identify clearly which aspects of PT they use. Finally,
we encourage more valid and consistent measurement of PT’s constructs. In short, we hope
that our work will lead to additional, yet richer, use of PT in the future.
An Introduction to Prospect Theory
The Historical Context of PT
The literature on decision making under risk emerged from efforts to understand indi-
viduals’ preferences in games of chance (Bernstein, 1996; Tversky & Kahneman, 1986).
Before proceeding with our discussion of this literature, we clarify several definitions in
Table 1. In general, researchers working in this area follow Knight (1921), who used the
term risk to describe a situation in which an individual making a choice knows both the
potential outcomes of each available option and the probabilities that those outcomes will
occur. Scholars often use expected value, which is the probability-weighted average of the
outcomes that could result from a choice, as the baseline against which to evaluate individu-
als’ risk-taking preferences. For example, as Table 1 illustrates, choosing a sure option
(i.e., the outcome has a 100% probability of occurrence) over a probabilistic option with
greater expected value is evidence of risk aversion, whereas selecting a probabilistic option
with a lower expected value is evidence of risk seeking (Kühberger, 1998).2 Table 1 also
contains several other definitions pertinent to the following discussion.
In a seminal work, Bernoulli (1738/1954) offered a theory to explain why individuals
often do not choose the available option with the highest expected value (Schoemaker,
1982). His explanation distinguished between the objective value of an outcome and its util-
ity, which reflects the pleasure it provides for the decision maker. Rather than expected
value, he suggested that people value a gamble based on its expected utility, which is the
probability-weighted average of the utilities for each of the outcomes (i) that could result
from the choice (see Table 1),
Expected utility (gamble) = ∑Ni= 1 u (i) ∗ p(i), (1)
where u(i) connotes the utility of outcome i and p(i) connotes the probability that i will
occur.
In expected utility theory (EUT), individuals derive utility from their final wealth posi-
tions (i.e., the outcome of the gamble plus their current wealth). More specifically, the utility
individuals derive from additional units of an outcome depends on how many units of that
outcome the individuals already possess. Bernoulli, for example, argued that a poor person
Table 1
Definitions of Key Concepts
Concept Definition
Decision weight Depicts the influence of a probability on the value of a gamble
Diminishing The difference between the subjective values of two outcomes is larger, the closer those
sensitivity outcomes are to the reference point
Expected utility The probability-weighted average of the utilities of a gamble’s outcomes, where utility
refers to the pleasure the final wealth positions (i.e., current wealth plus the outcome of
the gamble) will provide (von Neumann & Morgenstern, 1944)
Expected value The probability-weighted average of a gamble’s outcomes (Edwards, 1954)
Framing An individual’s interpretation of a decision (Tversky & Kahneman, 1981)
Gain frame Anticipating an outcome in excess of one’s reference point (Tversky & Kahneman, 1981)
Loss aversion A tendency to prefer minimizing losses to maximizing equivalent magnitude gains
Loss frame Anticipating an outcome below one’s reference point (Tversky & Kahneman, 1981)
Mixed gambles Gambles that offer both positive and negative outcomes
Probability Translates probabilities into decision weights
weighting function
Pure gambles Gambles that offer strictly positive or strictly negative outcomes
Reference point The neutral position used to determine the extent to which outcomes constitute gains (which
are above this position) or losses (which are below this position)
Risk Situations in which both outcomes and their probabilities of occurrence are known to the
decision maker (Knight, 1921)
Risk aversion Preferring sure outcomes to probabilistic outcomes with greater expected value
Risk seeking Preferring probabilistic outcomes to sure outcomes with greater expected value
Subjective value Depicts the value an individual perceives an outcome to be worth, reflecting the pleasure the
outcome will provide
Value function Translates outcomes into subjective values
Note: Unless otherwise noted, these definitions are derived from Kahneman and Tversky’s (1979) work.
would derive greater added utility from a given sum of money than a rich person would.
According to this view, the relation between money and utility is concave because additional
money provides progressively less added utility. Thus, “Bernoulli’s great innovation was to
abandon the standard way of evaluating gambles by their expected value” in favor of a focus
on individuals’ idiosyncratic preferences (Kahneman, 2003: 703).
Von Neumann and Morgenstern (1944, 1947) developed several decision-making axioms
to argue that rational individuals, who know and can process all information relevant to a
choice, should choose the available alternative with the highest expected utility. By exten-
sion, an individual’s choices should be invariant to the way he or she receives information
(Edwards, 1954). Over time, EUT became the normative standard in research on decision
making under risk. Furthermore, the rational prescriptions EUT offered became the concep-
tual foundation for much of the descriptive literature on such decision making (Schoemaker,
1982; Slovic, Fischhoff, & Lichtenstein, 1977).
Against this backdrop, management researchers have emphasized two alternative theories
to explain risk-related behaviors: the BTOF and PT. In the BTOF, March and Simon (1958)
and Cyert and March (1963) described how bounded rationality, which reflects human limi-
tations in accessing, processing, and using information (e.g., Simon, 1957), influences
Table 2
A Comparison of Expected Utility Theory, Prospect Theory,
and the Behavioral Theory of the Firm
Behavioral Theory of the
Expected Utility Theory Prospect Theory Firm
Representative work Bernoulli (1738/1954), Kahneman and Tversky (1979), Cyert and March (1963),
von Neumann and Tversky and Kahneman (1992) March and Simon (1958)
Morgenstern (1944)
Level of analysis Individual Individual Organizational
Form of rationality Rationality Bounded rationality Bounded rationality
Reference point None One neutral reference pointa Many aspiration levelsb
Predictor of risk- S utility × probability; v (x) × p (p) + v (y) × p (q)c Performance relative to
taking preferences summation over all v (y) + p (p) × [v (x) – v (y)]d aspirations
outcomes
a. Generally, prospect theory assumes that the reference point is the status quo. Aspirations, expectations, norms,
and social comparisons can shape the reference points people use (Tversky & Kahneman, 1991).
b. Current aspiration levels may reflect stakeholder preferences, past aspiration levels, past performance, and the
performance of comparable organizations (Cyert & March, 1963).
c. This equation applies to mixed gambles, gambles that include 0 as an outcome, and gambles for which the
probabilities add to less than 1.
d. This equation applies to pure gambles with probabilities that add to 1.
decision-making processes in organizations. For example, the BTOF suggests that organizations
compare their performance to aspiration levels, which are akin to goals, and this comparison
shapes their risk-taking preferences.
PT, our main focus here, is part of a vast literature in behavioral decision theory (BDT)
demonstrating that EUT models make “predictions that are not borne out by actual behavior”
(Slovic et al., 1977: 11). Like the BTOF, a central theme of BDT is that people’s decisions
often reflect bounded rationality. Tversky and Kahneman (1974) brought this work to a
wider audience, emphasizing heuristics and biases that individuals use to make decisions.
However, prior to the development of PT, BDT lacked a unifying theory of individual risk
taking.
Kahneman and Tversky (1979) drew on findings from earlier BDT research to develop
PT, which challenged EUT’s predictions about individual-level decision making under risk.
PT “departs from the tradition that assumes the rationality of [individuals]; it is proposed as
a descriptive, not a normative, theory” (Tversky & Kahneman, 1992: 317). As we introduce
PT below, we also draw attention to an extension of PT, termed cumulative prospect theory
(CPT). Developed by Tversky and Kahneman (1992), CPT makes substantively similar
predictions to those of PT in many respects, but the two theories differ slightly. We discuss
these differences and their implications where appropriate.
In our discussion below, we also emphasize how PT’s assumptions and arguments depart
from those of EUT. Subsequently, we discuss how PT differs from the BTOF. We summarize
the differences between these three theories in Table 2. Our intent is to describe PT’s predic-
tions in detail while highlighting their specificity and uniqueness.
Prospect Theory
PT predicts individuals’ choices in decisions that involve risk. In developing the theory,
Kahneman and Tversky (1979) relied on controlled experiments that offered individuals
choices between alternatives, each of which contained possible outcomes and their respec-
tive probabilities of occurrence.
Based on the results of such experiments, Kahneman and Tversky (1979) concluded that
people’s choices could be described by a model that (a) converted the outcomes of gambles
into subjective values (i.e., the pleasure the outcomes provide) and (b) weighted these sub-
jective values by decision weights (i.e., the impact of probabilities on choice). In addition,
they developed (a) the value function to describe how individuals determine the subjective
values of outcomes and (b) the probability weighting function to define the relations
between probabilities and decision weights. We refer to these two functions as the two cen-
tral components of PT.
Moreover, PT predicts that individuals choosing between two gambles will select the
one with the highest value. As Table 2 suggests, whereas EUT uses Equation 1 to calculate
the value of a gamble, PT does so using one of two equations (depending on the type of
gamble).
Before describing either of these two equations or PT’s two central components in detail,
we emphasize that PT does not assume individuals consciously perform the operations
depicted in the value function and the probability weighting function, nor does PT assume
individuals consciously calculate the value of gambles. Rather, both of PT’s central compo-
nents and both equations are analytical tools inferred from extensive experimental data
(Kahneman, 2003).
PT uses Equation 2a to calculate the value of mixed gambles, which include both posi-
tive and negative outcomes, gambles that include 0 as an outcome, and gambles with prob-
abilities that sum to less than 1. According to PT, the value of such gambles is a weighted
sum of the subjective values and decision weights for the i possible outcomes. For example,
consider a gamble with outcomes x and y with probabilities p and q, respectively. PT rep-
resents the value of the gamble as follows,
Value of a Gamble = n (x) ∗ p (p) + n (y) ∗ p (q), (2a)
where v() connotes the subjective value of an outcome and p() connotes the decision weight
for a probability.
PT uses Equation 2b to calculate the value of gambles that contain only positive or nega-
tive outcomes (i.e., pure gambles) and have probabilities that sum to 1. In particular, PT
divides the gamble into a riskless portion and a risky portion. For example, consider the
above gamble with outcomes x and y and probabilities p and q, and assume the subjective
value of each outcome is positive. If v(y) < (v)x, then the decision maker is guaranteed to
receive at least (v)y from the gamble. Thus, (v)y is the riskless portion of the gamble. The
difference between v(y) and v(x) is the risky portion, which will occur with probability p. In
turn, to calculate the value of the gamble, PT (a) multiplies the risky portion by the decision
Figure 1
A Hypothetical Value Function (Tversky & Kahneman, 1992)
20
10
0
–30 –20 –10 0 10 20 30
–10
–20
–30
–40
x: Outcomes
y: Subjective Value
weight for p and (b) adds this product to the riskless portion. In other words, PT calculates
the value of the gamble as follows,
Value of a Gamble = n (y) + p (p) ∗ [n (x) - n (y)], (2b)
Importantly, as Equations 2a and 2b illustrate, PT is primarily concerned with individuals’

choices between two alternatives. Conversely, CPT “applies to any finite [gamble],” regard-
less of the number of outcomes (Tversky & Kahneman, 1992: 302), a point to which we will
return later. We now discuss the two central components of PT in detail.
The PT value function. Figure 1 illustrates a hypothetical value function, which depicts the
relation between outcomes and their subjective values.3 As Kahneman and Tversky (1979) and
Tversky and Kahneman (1992) explained, four properties of the value function merit emphasis.
First, individuals evaluate outcomes relative to reference points. Thus, whereas the utili-
ties of a decision’s outcomes in EUT depend on one’s final wealth position, PT assumes that
people code the outcomes of a decision into gains or losses, which are “defined relative to
some neutral reference point” (Kahneman & Tversky, 1979: 274). Outcomes above the
reference point are viewed as gains, and outcomes below it are viewed as losses. In this
sense, PT assumes that “perception is reference dependent” (Kahneman, 2003: 703).
Second, as Figure 1 illustrates, the value function is concave above the reference point
and convex below it. This pattern contributes to risk-seeking preferences for gambles involv-
ing only losses (i.e., outcomes below the reference point) and risk-averse preferences for
gambles involving only gains (i.e., outcomes above it).4 In contrast, most EUT applications
assume that individuals are risk averse for both positive and negative outcomes (Schoemaker,
1982), though some applications also allow for risk seeking for some decisions (e.g.,
Markowitz, 1952).
Third, the value function incorporates diminishing sensitivity. Specifically, when addi-
tional increments of an outcome are further from the reference point, they provide progres-
sively smaller increments of subjective value. For example, if the reference point is $0,
the difference between the subjective values of $100 and $200 is greater than the difference
between the subjective values of $10,100 and $10,200. Stated differently, the subjective
values of outcomes above (below) the reference point increase (decrease) at decreasing rates.
In turn, for gambles involving two outcomes far above or far below the reference point, the
value function is nearly linear, suggesting that individuals’ preferences approach risk neu-
trality. On the surface, PT’s notion of diminishing sensitivity appears similar to EUT’s argu-
ment that additional increments of wealth provide progressively less utility as individuals’
wealth increases. However, PT suggests that the rate at which added subjective value
declines depends on the distance of the outcomes from the reference point, whereas EUT
suggests that the rate of decline depends on one’s final wealth position.
Fourth, PT assumes that individuals are loss averse, meaning that they generally find the
displeasure of losses to be greater than the pleasure of equivalent magnitude gains. In other
words, reflecting earlier findings, PT assumes that people simply do not “like to lose”
(Edwards, 1954: 396). For example, many individuals would prefer a gamble with equally
likely outcomes of $0 and $200 to a gamble with equally likely outcomes –$100 and $300,
even though the expected values (i.e., $100) are identical. Reflecting this loss aversion,
Figure 1 is steeper for losses than it is for gains. In contrast, loss aversion plays no role in EUT.
The PT probability weighting function. The probability weighting function converts a

gamble’s probabilities into decision weights. Because PT uses decision weights to calculate
the value of gambles (see Equations 2a and 2b), the probability weighting function is an
important aspect of PT.
Figure 2 contains hypothetical probability weighting functions depicting relations
between probabilities and decision weights.5 Unless stated probabilities are 0 or 1 (in which
case decision weights are 0 and 1, respectively), “decision weights do not coincide with
stated probabilities” (Kahneman & Tversky, 1979: 277). Specifically, PT suggests that
people underweight most probabilities, particularly large ones, but overweight probabilities
near 0. Underweighting (overweighting) implies that the influence of the probability on the
value of the gamble is less than (greater than) the influence of the actual probability would
be (see Equations 1, 2a, and 2b).
Consistent with arguments proposed by Allais (1953), PT also suggests that small differ-
ences in probabilities near the endpoints of the probability scale (i.e., 0% and 100%) elicit
large differences in decisions weights. In contrast, people are rather insensitive to differences
in probabilities in the middle of the scale (Fennema & Wakker, 1997). Therefore, according
to PT, relations between decisions weights and stated probabilities, though positive, are
Figure 2
Hypothetical Probability Weighting Functions (Tversky & Kahneman, 1992)
Panel A. Probability weighting function for gains

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
x: Probability
y: Decision Weight (Gain)
Panel B. Probability weighting function for losses

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
x: Probability
y: Decision Weight (Loss)
nonlinear. This pattern of underweighting and overweighting gives a reverse S shape to the
probability weighting function. Thus, in PT, the influence of a small change in probability
on the value of a gamble depends on where along the probability scale that changes occurs.
Conversely, in EUT, changes in probability have linear effects on the value of a gamble (i.e.,
the effect is the same regardless of where along the probability scale that change occurs).
Finally, we note that a key difference between CPT and PT lies in the probability weight-
ing function. Unlike PT, CPT “allows different decision weights for gains and losses”
(Tversky & Kahneman, 1992: 302). Specifically, as Figure 2 illustrates, the probability
weighting function for gains exhibits greater curvature than does the probability weighting
function for losses. In this sense, CPT suggests that people have “different attitudes toward
probability for gains than for losses” (Fennema & Wakker, 1997: 55). In contrast, PT implic-
itly assumes that probabilities influence decisions similarly for gains and losses.
Framing
The reference point plays a critical role in PT. In particular, the reference point determines
how individuals frame (i.e., interpret) the outcomes of a decision. For example, individuals
using one reference point may frame a given outcome as a gain, while individuals using a
different reference point may frame the same outcome as a loss (Bazerman, 1984).
Thus, scholars can test PT by manipulating framing. Frequently, framing manipulations
involve presenting identical information using different wording (Kühberger, 1998). In par-
ticular, manipulations that alter the reference points people use are often appropriate for
testing PT (Levin, Schneider, & Gaeth, 1998).
To illustrate, many experimenters have tested PT using the Asian disease problem. Study
participants are told that a given disease is expected to kill 600 people. Some individuals are
given a decision option that would save 200 people, encouraging these individuals to use 600
deaths as the reference point. Thus, they frame this option as a gain. Conversely, other indi-
viduals are given a decision option that would kill 400 people, encouraging these individuals
to use 0 deaths as the reference point. Thus, they frame this option as a loss. Although sav-
ing 200 people is equivalent to killing 400 in this example, study participants tend to be risk
averse when they view choices involving the former decision option (i.e., the gain frame)
but tend to be risk seeking when they view choices involving the latter (i.e., the loss frame)
(Kühberger, Schulte-Mecklenbeck, & Perner, 1999; Tversky & Kahneman, 1981).6
Distinguishing PT from the BTOF
We now turn to the other major theory used in management studies of risk, the BTOF. As
Table 2 illustrates, the BTOF uses organizational performance relative to aspirations to pre-
dict risk taking. For example, Cyert and March (1992: 228) argued that when organizations
are performing “close to a target [i.e., aspiration level], they appear to be risk-seeking below
the target, [and] risk-averse above it.” Likewise, PT suggests that individuals are often risk
seeking and risk averse for gambles involving outcomes below and above the reference
point, respectively, especially when those outcomes are near the reference point. Thus, in
some respects, the BTOF and PT are similar. However, they also differ in important ways.
A basic difference is that PT is a theory of individual behavior, while the BTOF is a theory
that describes the behavior of organizations. In turn, the two theories emphasize different
subject matter. Specifically, the BTOF offers a detailed account of decision-making processes
in organizations.7 In contrast, although PT predicts behavior, it is relatively silent on the
cognitive processes underlying such behavior. By extension, the BTOF specifies many con-
structs (e.g., organizational slack and routines) that do not have direct counterparts in PT.
Similarly, although the reference point in PT and the aspiration level in the BTOF each
divide outcomes into those that are desirable versus undesirable, the BTOF contains detailed
theory describing the sources of aspiration levels, whereas PT does not have such a theory
of reference points. Specifically, as Table 2 illustrates, the BTOF suggests that an organiza-
tion’s aspiration levels reflect its stakeholders’ preferences, its past aspiration levels, its past
performance, and the performance of comparable organizations (Cyert & March, 1963). This
level of specificity has enabled researchers to offer a number of proxies for aspiration levels
and, in some cases, to measure aspiration levels directly. Although PT research often uses
the status quo as the reference point (Kahneman, 2003), like other individual-level theories
of decision making under risk, PT generally lacks “a satisfactory theory of how reference
[points] are established and, for that matter, good empirical ways of estimating them
directly” (Luce, 1996: 192). Instead of measuring reference points, PT experimenters often
impose reference points using framing manipulations similar to the Asian disease problem
described above (Kahneman, 1992).
In other respects, however, PT offers greater specificity than the BTOF does. For exam-
ple, PT’s predictions rest on its two central components, which together define the values of
gambles. By extension, PT explains decisions that involve specific outcomes and probabili-
ties. Conversely, the BTOF describes how managers search for and select solutions that will
produce organizational performance above aspirations. Thus, the BTOF does not require that
managers know either the outcomes of the decisions or the probabilities of those outcomes.
In this sense, the BTOF can apply to more ambiguous and ill-defined choices than those PT
describes.
Likewise, in part due to the decisions the BTOF describes, its predictions about risk tak-
ing are also more complex than are those researchers have derived from PT. To illustrate, the
BTOF suggests that when firm performance exceeds aspirations by a large amount, firms’
risk-taking preferences may switch from risk aversion to risk seeking (Cyert & March, 1963;
March & Shapira, 1992). Conversely, firms with exceptionally poor performance may
change aspiration levels and aspire simply to survive (March & Shapira, 1987). The BTOF’s
predictions regarding whether low-performance firms become risk averse or risk seeking
depend on whether managers perceive the firm’s survival is threatened. In contrast, PT’s
value function clearly predicts that preferences approach risk neutrality when outcomes are
far from the reference point.
As this discussion and Table 2 suggest, PT’s predictions are distinct from those of both
EUT and the BTOF. As we demonstrate later, PT’s predictions are also more complex than
many researchers have assumed (see Bromiley, 2010). In the following sections, we identify
and review management research drawing on PT. This review shows that although PT con-
tains two central components, management research generally makes predictions exclu-
sively based on the value function while ignoring the probability weighting function.
Identifying PT Research in Management
According to Web of Science, scholars have cited the Kahneman and Tversky (1979)
article that introduced PT more than 6,100 times. In addition, scholars have cited Tversky and
Kahneman’s (1992) article that introduced CPT more than 1,300 times. More than 550 articles
citing either of these two studies (or both) have appeared in periodicals consistently recog-
nized as top academic journals for management research (see Note 1 for a list of the journals
we used). Given the considerable size of this literature and space limitations, we employed four
steps to narrow our scope and attempt to capture the most appropriate research for this review.
We first searched for articles using the search terms prospect theory and loss aversion. We
included the latter term because loss aversion is the most frequently used aspect of PT in the
management literature. This search returned 189 articles. Second, we examined these articles
for appropriateness and fit. To focus more precisely on PT-based research, we eliminated
15 articles that did not cite Kahneman and Tversky (1979) or Tversky and Kahneman (1992).
Our review revealed that several influential studies in management that drew on PT did not
appear in the sample (e.g., Amit & Schoemaker, 1993; Neale & Bazerman, 1985). Therefore,
in our third step, we added the top 5% of articles (based on citation counts per year) pub-
lished in leading management journals that cited either of the two seminal PT articles. This
step helped ensure that we captured the most impactful studies in management that drew on
PT. This step added 17 articles to our sample,8 bringing the total to 191 articles.
Of this 191, we focused on 81 articles that used PT to describe decisions frequently con-
fronted by managers. We term these 81 articles management theory applications of PT. The
other 110 articles were decision analysis applications of PT. Due to the advanced state of PT
research in the decision analysis literature, we draw insights from these articles to enrich our
analysis and future research suggestions.
Management Theory Applications of PT at the Individual Level
In this section, we review management theory applications of PT at the individual level.

Reflecting the focus of prior work, we consider studies using PT to examine executive com-
pensation, negotiations, affect and motivation, and HRM.
Executive Compensation
We identified seven executive compensation studies at the individual level that drew on
PT. Traditionally, much of the literature on executive compensation has emphasized agency
theory (Devers, Cannella, Reilly, & Yoder, 2007). Agency theory generally assumes risk-
averse executives, risk-neutral shareholders, and a positive association between organiza-
tional risk and return. With these assumptions, agency theorists suggest that shareholders
should tie a portion of executives’ compensation to organizational returns, thereby discour-
aging executive risk aversion (Jensen & Meckling, 1976).
In contrast to agency theory, PT states that individuals sometimes evidence risk-seeking,
rather than risk-averse, behavior. Therefore, Eisenhardt (1989) suggested that PT’s insights
about risk taking could inform agency theory research on executive compensation. Thus far,
executive compensation research drawing on PT has emphasized two concepts from the
value function: the reference point and loss aversion. These studies illustrate why such
compensation often fails to produce executive behavior consistent with shareholder interests
(e.g., Walsh & Seward, 1990).
For example, Wiseman and Gomez-Mejia (1998) integrated concepts from agency theory
and PT to develop the behavioral agency model (BAM), which assumes that executives are
loss averse and that their compensation plans create reference points for them. In particular,
executives may perceive that the exercise price of their stock options is an important refer-
ence point. When the price of the stock underlying their stock options exceeds the exercise
price, executives may adopt gain frames and, consistent with PT, become risk averse.
However, high incentive pay targets can lead executives to adopt loss frames and, therefore,
become risk seeking. Thus, building on arguments from PT, the BAM suggests that execu-
tive compensation plans can either discourage or encourage risk aversion, depending on how
executives view the relation between firm outcomes (e.g., the stock price) and the reference
points (e.g., the exercise price) such plans make salient.
Extending this insight, Devers, Wiseman, and Holmes (2007) used a policy capturing
approach to examine the subjective values managers placed on stock options. In particular,
they used the prices managers assign to stock options as a proxy for subjective values. They
argued that rising stock prices elicit gain frames and declining prices elicit loss frames.
Furthermore, they assumed that stock price volatility reflects the risk of the underlying stock
(e.g., Sharpe, 1964). Consistent with their expectations, they found evidence that managers
assigned a premium for stock price volatility when stock prices were declining but dis-
counted for volatility when stock prices were increasing.9 They interpreted this result as
evidence that, consistent with the value function, managers are risk seeking in loss frames
and are risk averse in gain frames. This results contrasts with an assumption of the Black–
Scholes (1973) model, which assumes that the value of stock options relates positively to
volatility, regardless of stock price trends. Therefore, if compensation committees rely
exclusively on the Black–Scholes logic to design stock option packages, changes in the
volatility and trend of the underlying stock price could result in managers perceiving that
they are overcompensated or undercompensated.
Scholars have also used PT to examine when and how executives decouple their wealth from
firm performance, thereby circumventing some of the intended effects of incentive compensa-
tion (Bebchuk & Fried, 2006). For example, Matta and McGuire (2008) argued that CEOs are
loss averse, and strong firm performance decreases their concerns about the potential losses
stemming from equity-based pay. Consistent with this argument, these scholars found that
CEOs were more likely to reduce equity holdings and tended to reduce them by a larger mag-
nitude when firm performance was poor. Likewise, also arguing that executives are loss averse,
Dunford, Oler, and Boudreau (2008) found that executives increasingly left their firms volun-
tarily when the price of the firm’s stock was far below the exercise price. Thus, although many
firms use stock options as a retention mechanism (Fulmer, 2009), the value function provides
insight into conditions when this form of compensation might increase executive turnover.
In short, despite drawing only on PT concepts related to the value function, these studies
have modified extant management theory by showing that executive compensation can
motivate either risk-averse or risk-seeking behaviors, depending on whether recipients
frame the potential consequences of those behaviors as gains or losses. The studies also
identify conditions that encourage executives to alter their exposure to the downside conse-
quences of equity-based pay. However, this area of study also illustrates two shortcomings
of many management theory applications of PT.
First, these findings rest heavily on whether scholars have correctly identified the reference
point. Because PT lacks a theory of reference points, scholars have had to make somewhat
arbitrary assumptions in this regard. For example, the observation that some executives use
the value of their stock options as loan collateral (Devers, Wiseman, et al., 2007) suggests that
they may use reference points other than the exercise price. Indeed, consistent with the notion
that managers often focus on the best or worst possible scenario (March & Shapira, 1987),
some executives may use a stock’s highest or lowest recent prices as a reference point. Second,
none of these studies considers other important PT concepts, such as diminishing sensitivity
and decision weights. We return to both of these issues in a broader discussion below.
Negotiations
We found six studies that used PT to study negotiations. These studies often experimen-
tally manipulated the frames negotiators used to make decisions and examined the influence
of such frames on bargaining behavior and outcomes. For example, researchers can create
gain frames by instructing study participants that they are negotiating over profits they will
receive. Conversely, researchers can create loss frames by instructing the participants that
they are bargaining over expenses they must pay (De Dreu, Carnevale, Emans, & Van de
Vliert, 1994). In general, these studies relied on insights from the value function, especially
loss aversion and reference points. However, some of the studies also considered the effects
of diminishing sensitivity in the value function.
Researchers have identified three consequences of loss aversion for negotiations. First,
negotiators in loss frames may become risk seeking and behave aggressively, while negotia-
tors in gain frames may become risk averse and behave cooperatively. For example, Neale
and Bazerman (1985) told study participants either to minimize their losses in the negotia-
tion or to maximize their gains, presumably placing them in loss frames and gain frames,
respectively. These scholars found that the loss-frame negotiators made fewer concessions
and acted more competitively than gain-frame negotiators did.
The second consequence of loss aversion can explain why agreements are sometimes
difficult to reach in negotiations. Negotiators tend to view their own concessions as losses
and those of their counterparts as gains. Reflecting loss aversion, negotiators value their
concessions (which they view as losses) roughly twice as much as they value equivalent
magnitude concessions by their counterparts (which they view as gains). In turn, they may
be unwilling to make concessions (Kahneman, 1992; Kahneman & Tversky, 1995).10 If each
negotiator approaches the negotiation this way, “the resulting four-to-one gap may be diffi-
cult to bridge” and the negotiators may have difficulty reaching an agreement (Tversky &
Kahneman, 1986: 262; also see Bazerman, 1984). For example, negotiations involving two
individuals attempting to minimize their losses (i.e., they are in loss frames) often end in
impasses wherein no final settlement is reached (Bottom & Studt, 1993).
Together, these two consequences of loss aversion provide a foundation for several nego-
tiations studies. For example, Kristensen and Garling (1997) examined negotiations over the
price of a good. They created gain (loss) frames for buyers by setting the seller’s initial offer
price for the good below (above) the buyers’ reservation prices. They found that buyers in
gain frames made fewer counteroffers, were more likely to reach an agreement, and pur-
chased the good at a higher price than buyers in loss frames did. Thus, this study is consistent
with earlier work suggesting that gain frames promote cooperation. It also suggests that gain
frames may reduce the likelihood of impasse in negotiations.
However, Bottom (1998) examined a situation in which loss frames can have similar
effects. In particular, he created a scenario wherein individuals reaching a settlement in a
negotiation would have to play a gamble to determine how much money they would receive
or pay. As such, reaching a settlement created risk for negotiators. If gain-frame individuals
are risk averse, they should be reluctant to reach a settlement in this scenario. Conversely, if
loss-frame individuals are risk seeking, they should be eager to reach a settlement. Consistent
with his expectations, Bottom found that loss-frame negotiators were more cooperative and
were more likely to reach a settlement than gain-frame negotiators were. This study under-
scores why scholars should understand what constitutes risk in a given decision.
Examining another interesting phenomenon, De Dreu et al. (1994) considered how nego-
tiators behave when they know their counterparts are in gain or loss frames. These scholars
found that negotiators perceived that their counterparts were more cooperative when they
knew the counterparts were in loss frames. Perhaps as a result, they conceded less to and
demanded more from opponents in loss frames. Thus, this study suggests that people’s nego-
tiating behavior may depend on what they know about their counterpart’s frame.
A third way scholars have used loss aversion in negotiations research is to explain the
types of concessions a negotiator will value most. Specifically, a counterpart’s concessions
may mean more to a negotiator when they reduce the negotiator’s losses, relative to when
they increase his or her gains (Northcraft, Brodt, & Neale, 1995). Scholars have examined
this argument by drawing on another of the value function’s properties, diminishing sensitivity.
For example, Northcraft et al. (1995) proposed that, due to the curvature of the value
function, a negotiator will value a counterpart’s concessions more when they involve out-
comes near the negotiator’s reference point. This diminishing sensitivity can produce several
interesting paradoxes in negotiations. To illustrate, as Northcraft et al. explained, assume an
individual is bargaining for concessions in two different categories of outcomes, and one of
these categories is more important to him or her than the other one is. If that person receives
a concession near the reference point in the less important category, he or she may value that
concession more than a concession further from the reference point in the more important
category. This study demonstrates the importance of understanding the reference points
people use to determine the subjective values of outcomes.
In another interesting demonstration of diminishing sensitivity, Northcraft, Preston,
Neale, Kim, and Thomas-Hunt (1998) created schedules specifying the outcomes partici-
pants were allowed to concede in a negotiation. These schedules resembled value functions
of different shapes. Specifically, some schedules reflected diminishing sensitivity in that, as
individuals made more concessions, subsequent ones were less important. The schedules for
other individuals specified either that all concessions were equal (i.e., linear sensitivity) or
that subsequent successions were more important than were earlier concessions (i.e., increas-
ing sensitivity). Consistent with their expectations, these scholars found that diminishing
sensitivity in the value function enabled the negotiators to reach an agreement beneficial to
both of them.
In sum, studies on negotiations provide several insights into the effects of framing on
decisions. Furthermore, the studies underscore the need to understand both how people view
risk in a given decision and which reference point they use to evaluate the relevant out-
comes. For example, owing to diminishing sensitivity, individuals may be ambivalent about
changes in gains and losses far from the reference point. Likewise, a person may frame an
outcome as a loss, even if that outcome only reduces his or her gains.
Affect and Motivation
We identified eight studies drawing on PT to study affect (i.e., positive or negative states,
feelings, moods, or emotions that change over time; e.g., J. M. George, 1991) and motivation
(i.e., internal forces that encourage individuals to engage in and maintain certain behaviors;
e.g., Steers & Porter, 1991) in diverse settings. These studies drew their predictions primar-
ily from the value function. In particular, they generally considered the concept of loss aver-
sion and, to lesser extents, reference points and diminishing sensitivity.
Three studies drew on loss aversion to explain employee motivation. Steel and Konig
(2006), for example, argued that individuals separate attributes of a task into gains (e.g., its
rewards) and losses (e.g., its costs). Consistent with loss aversion, they hypothesized that
individuals view tasks more favorably and are more motivated to engage in them when they
offer immediate gains and delayed losses. Similarly, also drawing on loss aversion, Grant
(2007) theorized that employees are attuned to the impact their work has on other people,
and they perceive that their work has greater impact when that work minimizes organiza-
tional losses (e.g., prevents crises), relative to when the work creates gains for the organiza-
tion (e.g., improves its image). Furthermore, Heath, Knez, and Camerer (1993) argued that
employees become accustomed to the financial and other benefits the organization provides.
In turn, reflecting loss aversion, employees may react negatively and their motivation may
decline when their organizations eliminate or reduce such benefits.
In addition, van Buiten and Keren (2009) examined the language people use to motivate
others. Specifically, they studied the tactics people use to convince others to select high-risk
or low-risk options. They found that people who promote a low-risk option try to encourage
other people to view that option through a gain frame rather than a loss frame. Because gain
frames tend to evoke risk-averse preferences, using gain frames to promote low-risk policies
may be an effective way to motivate employees. In contrast, however, people promoting
high-risk options did not believe that loss frames were more convincing than gain frames
were. In turn, they may have difficulty convincing people to select high-risk policies. As we
emphasize further below, this study illustrates the importance of understanding how indi-
viduals interpret decisions.
Regarding affect, Coughlan and Connolly (2001) examined how reference points and loss
aversion influenced individuals’ satisfaction with their performance on a task. Specifically,
individuals experienced dissatisfaction or satisfaction when their performance was below or
above, respectively, the performance level they expected to achieve. Thus, a person’s perfor-
mance expectations may constitute an important reference point for him or her. Moreover,
consistent with loss aversion, individuals may experience greater dissatisfaction when
performance is below their expectations than the satisfaction they experience when
performance exceeds their expectations. Accordingly, this study further supports the argument
that individuals may evaluate the same outcome differently depending on the reference point
they use.
Other scholars have drawn on diminishing sensitivity in the value function to examine
individuals’ affective responses to their level of voice in decisions (i.e., their perceptions
that they have been able to convey their preferences, concerns, etc.). For example, Hunton,
Hall, and Price (1998) found that voice positively influences individuals’ views about pro-
cedural fairness and decision control, as well as the individuals’ levels of satisfaction with
the decision. Further, consistent with diminishing sensitivity, the positive influence of addi-
tional voice declined as it reached higher levels. Extending this work, Price et al. (2001)
studied relations between voice and perceptions of fairness in participants from four coun-
tries (Great Britain, Mexico, the Netherlands, and the United States). Price et al. argued that
individuals may compare their levels of voice to reference points reflecting national norms
for voice in their home countries. For values of voice above and near the reference point,
the relation between voice and fairness had a concave shape. This result is consistent with the
shape of the value function. For values of voice far above the reference point, however,
the relation between voice and fairness had a convex shape, which is inconsistent with the
value function. Price et al. also showed that these results generally held for participants from
all four countries.
Despite the insights these studies have provided, they generally use concepts from PT in
a manner somewhat detached from the original arguments of the theory. For example, as a
theory of decision making under risk, PT does not speak directly to affect and motivation.
Thus, although relations among the variables in some of the studies coincided with the shape
of the PT value function, the results of such studies do not support PT directly. Indeed, the
PT value function describes only relations between outcomes and their subjective values to
decision makers. In addition, several studies did not specify a reference point. Absent a clear
reference point, the gains and losses of interest are somewhat ill defined.
HRM
Six studies drew on PT to examine HR-related questions. The majority of this research
examined selection and performance evaluation, but one study examined employees’ will-
ingness to accept HR policies. Again relying primarily on the value function, the studies
considered loss aversion, reference points, and diminishing sensitivity.
For example, Kristof (1996) argued that selection resembles a gamble with positive and
negative outcomes. Consistent with this argument, Highhouse and Johnson (1996) argued
that selectors used job incumbents’ performance as a reference point and evaluated the
anticipated performance of prospective candidates as gains or losses relative to this point.
Drawing on loss aversion, they found that people prefer a candidate who represents no per-
formance change from the incumbent over candidates whose possible performance repre-
sents a loss.
In addition, Wong and Kwong (2005a, 2005b) found diminishing sensitivity in selection
and performance evaluation. Specifically, decision makers perceived that differences between
job candidates were larger when low magnitude numbers quantified such differences (e.g., the
percentage of errors is 5% vs. 6%) than when high magnitude numbers did (e.g., the percentage
of nonerrors is 95% vs. 94%). In other words, consistent with a concave value function, addi-
tional units of high (low) magnitude outcomes were less (more) important to decision makers.
Thus, individuals may be able to manipulate similar decisions in organizations by varying the
presentation of information.
Finally, Bamberger and Fiegenbaum (1996) drew on concepts in PT to examine how
managers evaluate HR strategies. They argued that managers adopt loss or gain frames
depending on how HR-related outcomes compare to reference points, and this framing
increases those managers’ openness toward risk-seeking and risk-averse HR policies, respec-
tively. They further argued that, because individuals in the same organization may use dif-
ferent reference points, some managers will be in gain frames, while others will be in loss
frames. The resulting differences in risk-taking preferences may create conflict that disrupts
HR strategy implementation.
In short, some of these studies demonstrate that the value function may shape personnel
decisions in organizations. Again, however, this research largely ignores the probability
weighting function.
More broadly, the body of management research applying PT at the individual level of
analysis identifies several reasons that people in the same organization may interpret identi-
cal decisions differently. With this thought in mind, we now turn to reviewing research that
has used PT at higher levels of aggregation.
Management Theory Applications of PT

at Higher Levels of Aggregation
Although it is an individual-level theory, scholars often apply PT to explain higher-level

phenomena. Indeed, in contrast to the 28 individual-level studies we identified, we found 53
at higher levels of aggregation. Research utilizing PT at higher levels primarily falls into one
of two broad categories. The first uses firm performance distributions to explain relations
between firm risk and return. The second examines the antecedents and consequences of
firms’ specific risk-taking actions (e.g., acquisitions).
Organizational Risk and Return
Early applications of PT in the management literature examined relations between orga-

nizational risk and return. We identified 13 management studies in this area.
Much of this work draws on Bowman (1980), who measured returns as mean return on
equity over time and risk as the variance in such returns. He found negative associations
between organizational risk and return and termed this relation a paradox, because it runs
counter to the positive risk-return relation assumed in many finance and economics models
(Armour & Teece, 1978; Sharpe, 1964). Drawing on PT to explain negative risk-return rela-
tions, Bowman (1982) argued that firms use median returns in the industry as a reference
point. Noting that PT implies risk seeking when outcomes are below the reference point, he
argued that firms performing below the industry median take more risks.
Subsequent studies extended Bowman’s work by considering additional industries and
countries and by examining more intricate relations between organizational risk and return.
Studying U.S. firms in nearly 50 industries, for example, Fiegenbaum and Thomas (1988)
found a negative risk-return association for firms performing below the industry median but
found a positive association for firms performing above the industry median. Jegers (1991)
also found this general pattern of results in a sample of Belgian firms. The authors of both
of these studies concluded that their results supported PT.
More recent work offers three important criticisms challenging this conclusion. First,
many scholars have raised concerns related to research methodology.11 For example, manag-
ers may associate risk more with losses than with the variability in outcomes, raising ques-
tions about the use of variance measures to capture risk (March & Shapira, 1987). Building
on this observation, Miller and Leiblein (1996) introduced a measure of downside risk,
which they based on the lower partial moments of firms’ return distributions (also see Miller
& Reuer, 1996). In addition, Miller and Leiblein (1996: 91) found that “downside risk results
in improved subsequent performance. Performance shows a negative relation with subse-
quent downside risk.” Thus, the findings of organizational risk-return studies may hinge on
the risk measure used. As we discuss below, this possibility underscores the need to select
risk-taking measures carefully when testing PT.
A second criticism concerns the reference point. The BTOF research on aspiration levels
we discussed earlier suggests that managers may compare firm performance to criteria other
than industry performance metrics. Specifically, challenging the widespread use of median
performance in the industry as a reference point, Bromiley (1991b) argued that high-
performing firms clearly do not aspire to lower performance. Instead, such firms may use
their own performance history as a reference point. Likewise, as noted, firms in danger of
bankruptcy may focus on survival (March & Shapira, 1987). Of course, if firms are not using
the reference point researchers assume, results that appear to support PT may not do so
(Nickel & Rodriguez, 2002).
The third criticism concerns whether PT would actually predict a negative relation
between organizational risk and return. As we noted above, the PT value function implies
that risk aversion and risk seeking are strongest near the reference point, but they decline
toward risk neutrality when outcomes are far above and below the reference point, respec-
tively. Thus, as Bromiley (2010) argued, the PT value function would imply either a positive
association between organizational risk and return or no association at all.
In sum, Bowman’s (1980) early insights led to a number of studies investigating organi-
zational risk-return relations. However, this research stream is subject to criticisms related
to the measurement of risk and reference points. Furthermore, in our view, the PT value
function is inconsistent with a negative risk-return association, despite the claims of many
studies. To these criticisms, we add that this literature ignores the probability weighting
function.
In addition, we note that the risk evident in return distributions depends partly on the
risk-taking decisions of managers (Palmer & Wiseman, 1999). Reflecting this argument,
more recently, scholars have moved away from measures of firm risk based on the return
distribution in favor of specific measures of firm risk-taking behaviors.
Firm Risk-Taking Behaviors
Using similar arguments to those found in the risk-return studies above, several studies
have drawn on PT to examine firm risk-taking behaviors. Nearly half of all the articles
(40 out of 81) we reviewed fell within this area of research. This work generally assumes
that firm-level actions are manifestations of the risk-taking preferences PT predicts for indi-
viduals. Although the dependent variables are typically at the firm level, some of the studies
consider predictors at the individual level, while others consider predictors at higher levels.
As with the other work we have reviewed, these studies draw their predictions only from
the value function, and few of them consider diminishing sensitivity in the value function.
Individual-level antecedents of firm risk-taking behaviors. Amit and Schoemaker (1993)

argued that the frames managers adopt influence their decisions about how to use organiza-
tional resources. Some studies examine this possibility by arguing that managers perceive
that external threats increases the possibility of potential losses (Jackson & Dutton, 1988).
In turn, they use loss aversion to explain how managers respond to a variety of perceived
external threats to the firm. For example, Chattopadhyay, Glick, and Huber (2001) found
that CEOs who perceived threats to their organizations’ resources responded with externally
directed actions (e.g., adjustments to targeted markets), which the authors presumed were
riskier than were internally directed actions (e.g., adjustments to administrative procedures).
Similarly, E. George, Chattopadhyay, Sitkin, and Barden (2006) theorized that managers
become risk seeking when they perceive that threats to the legitimacy of the organization
will reduce its access to resources. In turn, they might respond through risky organizational
responses that are inconsistent with industry norms. Conversely, Sharma (2000) found that
managers may initiate strategies that conform to institutional pressures when threats involve
issues stemming from the organization’s impact on the natural environment.
As earlier discussed, scholars have also argued that incentive compensation creates gain and
loss frames for executives.12 Like the research we reviewed above, this work frequently assumes
that CEOs use the exercise price of stock options as a reference point. For example, Zhang,
Bartol, Smith, Pfarrer, and Khanin (2008) argued that CEOs frame underwater stock options as
possible losses, particularly when firm performance is poor. In turn, they argued that this loss
frame facilitates risky, unethical behavior (Lehman & Ramanujam, 2009). In support, they
found evidence that firms were more likely to exhibit earnings manipulations when CEOs’ stock
options were underwater, and this effect was stronger when the firms were performing poorly.
Other studies have drawn on PT to explain specific organizational actions involving large
resource commitments. For example, also assuming that CEOs use the exercise price of
stock options as a reference point, Larraza-Kintana, Wiseman, Gomez-Mejia, and Welbourne
(2007) found that as the values of the CEOs’ in-the-money stock options increased, firms
took less risk, which they measured using several organizational actions (e.g., new market
entries and capital investments). This result supports the notion that CEOs with positively
valued stock options adopt gain frames, which promote risk-averse behaviors at the firm
level. Likewise, Matta and Beamish (2008) argued that because CEOs are loss averse, they
adopt gain frames and become risk averse when they have lucrative equity holdings and
in-the-money stock options, especially when they near the end of their tenures. Using inter-
national acquisitions to measure risk taking, they found that as the value of aging CEOs’
equity holdings and in-the-money stock options increased, firms took less risk.
Departing from most prior work drawing on PT at higher levels of aggregation, Devers,
McNamara, Wiseman, and Arrfelt (2008) provided evidence of a curved value function for
in-the-money stock options. Using a variant of Miller and Bromiley’s (1990) strategic risk
measure (i.e., R&D intensity, capital investment intensity, and debt-to-equity ratio), Devers
and her colleagues provided evidence that the value of restricted stock held by CEOs was
negatively associated with firm risk taking. However, Devers et al. also argued that, consis-
tent with PT, the subjective values CEOs attach to stock options rise at a decreasing rate. In
other words, when the stock price is extremely high, further increases appear to be less
important to CEOs. In support, Devers et al. found that increases in the value of stock options
exhibited progressively weaker marginal impacts on the level of firm risk CEOs initiated.
Finally, a creative study by Pennings and Smidts (2003) estimated individuals’ value func-
tions and examined their implications in a field setting. Specifically, they constructed farmers’
value functions using the individuals’ preferences in a series of hypothetical choices, and
they found that the shape of those value functions differed across farmers. Farmers with
value functions exhibiting the S shape PT assumes (see Figure 1) tended to use production
systems where pricing fluctuations frequently produce significant gains and losses (e.g.,
purchasing animals). However, farmers whose value functions were not S shaped were more
likely to use production systems where gains and losses due to pricing fluctuations were less
of a concern (e.g., raising animals). They offered two alternative explanations for this result.
First, people who frequently make decisions involving gains and losses may develop
S-shaped value functions. Second, people with S-shaped value functions may prefer produc-
tion systems in which decisions involving gains and losses are commonplace.
Higher-level antecedents of firm risk-taking behaviors. Scholars have also drawn on the
value function, primarily loss aversion, to study higher-level antecedents of firm risk-taking
behaviors. Like the organizational risk and return studies, these studies argue that conditions
at the firm or industry level produce gain and loss frames for organizations as a whole,
thereby facilitating firm-level risk aversion and risk seeking, respectively. For example,
declining industry demand may create loss frames that facilitate risk seeking. Consistent with
this argument, Wood (2009) argued that declining industry demand encourages acquisitions.
Scholars have made similar arguments in several studies examining firms’ investments
in innovation, which are presumably risky. For example, Abrahamson and Rosenkopf
(1993: 492) argued that many organizations copy other firms’ innovations because, consis-
tent with loss aversion, the “perceived threat of a competitive disadvantage far outweighs the
perceived value of an equally large competitive advantage.” In other words, the possibility
of incurring losses by not copying innovations often weighs heavily in organizations.
Similarly, Mone, McKinley, and Barker (1998) theorized that firms experiencing perfor-
mance declines encounter possible losses, which encourage risk-seeking investments in
innovation. Strong performance, however, can place organizations in gain frames, facilitat-
ing investments in low-risk, existing products and services (W. K. Smith & Tushman, 2005).
In addition, two studies drew on loss aversion to explain interactions between organiza-
tions and external stakeholders. D’Aveni (1989) argued that creditors are loss averse, which
makes them hesitant to realize losses by forcing borrowers into bankruptcy. He argued that
this hesitancy is evidence of risk-seeking behavior because it reduces the funds available
to the creditor (e.g., through liquidation) if the borrower ultimately fails. Jawahar and
McLaughlin (2001) suggested that the risk-averse approach to managing stakeholders is to
address all of the needs of all stakeholders. Arguing that near-failing firms adopt loss frames
and become risk seeking, these scholars theorized that such firms neglect the interests of
some stakeholders and attend only to the interests of stakeholders most critical to immediate
survival.
Like the organizational risk-return studies above, some scholars have measured firm
performance relative to a reference point. These studies argue that performance below the
reference point creates loss frames and risk-seeking behavior, whereas performance above
the reference point creates gain frames and risk-averse behavior (Palmer & Wiseman, 1999).
Citing this argument, Markovitch, Steckel, and Yeung (2005) assumed that firms with stock
returns above (below) the industry average are in gain (loss) frames. In turn, they found that
firms with above-average (below-average) stock returns subsequently invested less (more)
in high-risk actions than in low-risk actions. In addition, arguing that divesting a previously
acquired business reflects risk aversion, Shimizu (2007) found that firms are likely to divest
such businesses when their performance is negative, but this effect weakens as their perfor-
mance decreases further.
Finally, some research has drawn on PT to examine how firm risk taking influences firm
performance. For example, using average performance in the industry as the reference point,
Wiseman and Catanach (1997) found evidence that below-average firm performance creates
loss frames and facilitates risk-seeking behavior. Furthermore, they found that the relations
between such behavior and subsequent performance (i.e., return on assets) were generally
negative (also see Latham & Braun, 2009). Conversely, Morrow, Sirmon, Hitt, and Holcomb
(2007) found evidence that investors responded positively when firms with declining perfor-
mance engaged in certain risk-taking behaviors (i.e., valuable and inimitable new product
introductions and mergers and acquisitions). They interpreted their results as evidence that
the stock market values some forms of risk seeking when firms have experienced perfor-
mance declines.
In short, drawing primarily on the value function, research on the antecedents of firm
risk-taking behaviors generally suggests that gain frames give rise to risk-averse behavior
and loss frames give rise to risk-seeking behavior at the firm level. Some studies have also
examined the firm performance consequences of the risk-taking behavior, but these results
may depend on both the type of risk examined and the performance measure used.
These studies also illustrate several inconsistencies in research that draws on PT to
explain higher-level phenomena. In particular, scholars have used different proxies for the
reference point. The BTOF and other work (Fiegenbaum, Hart, & Schendel, 1996; Short &
Palmer, 2003) argue that firms use many reference points and that they may change over
time. However, our lack of understanding of which reference points firms are using limits
our ability to compare results across studies and to conclude that the research on firms’ risk-
taking behaviors definitively supports PT. For example, W. R. Chen (2008) argued that firms
can use either past performance or industry median performance as reference points.
Importantly, he also found that performance above past performance levels increased R&D
intensity, but performance above the industry median decreased R&D intensity. Thus, we
could conclude that this study either supports PT or contradicts PT, depending on the refer-
ence point we assume. Furthermore, several of the studies we reviewed did not specify a
reference point at all. This practice resembles modeling risk taking as a function of wealth,
which may not fit PT’s assumptions.
In addition, the definition of risk can be especially problematic when scholars use PT at
higher levels. For example, whereas Shimizu (2007) used divestitures to measure risk-
reducing actions, Markovitch et al. (2005) used divestitures to measure high-risk actions.
Furthermore, although Latham and Braun (2009) used R&D as an indicator of risk seeking,
the results of factor analyses suggest that R&D intensity loads negatively when other mea-
sures of risk seeking, such as capital investments (Miller & Bromiley, 1990) or diversifica-
tion (Palmer & Wiseman, 1999), load positively. Likewise, whereas Mone et al. (1998)
argued that performance declines would facilitate risk-seeking investment in innovation,
Markovitch et al. (2005) argued that several forms of such investment (e.g., technology alli-
ances) are low-risk actions. In turn, these two studies reach conclusions that are somewhat
inconsistent with one another. Like inconsistencies in the reference point, the plethora of
risk-taking metrics makes it difficult to discern whether the firm risk-taking studies, as a
whole, definitively support PT.
In the discussions that follow, we offer suggestions to help scholars operationalize
reference points and risk-taking measures more consistently.
An Analysis of Management Theory Applications

of PT and Suggestions for Future Research
The previous two sections illustrated that research drawing on PT has made contributions
in diverse areas of management scholarship. We now turn to analyzing the use of PT in the
management literature and making suggestions for future research.
Before proceeding, we would like to emphasize that although few management theory
applications draw on CPT, it may be more appropriate for studying many topics than PT is.
Strictly speaking, as noted above, PT applies only to two outcome gambles, whereas CPT
can accommodate more than two outcomes. Thus, to the extent that many management deci-
sions involve more than two possible outcomes, we encourage greater use of CPT.
With this thought in mind, we organize the remainder of this section by discussing con-
cerns related to (a) using parts of PT while ignoring others, (b) interpreting the value func-
tion, (c) interpreting the probability weighting function, and (d) using PT in organizational
settings. Table 3 summarizes many of the issues we raise in this section.
Partial Use of PT
As our review demonstrated, management research drawing on PT typically considers

only the value function. More specifically, nearly all of the 81 studies drew on loss aversion
Table 3
Analysis and Future Research Directions
Partial Use of Prospect Theory (PT)
•• Studies almost uniformly ignore the probability weighting function
•• Research that does not consider the full model is not testing PT
•• Studies not using the full model must explain the effects of PT’s constructs
Interpretation of the Value Function
•• Declining curvature predicts risk neutrality for large gains and losses
•• PT’s isolation assumption questions the relevance of past performance
•• Many decisions are mixed gambles and may promote risk aversion
•• The value function may vary across firms and individuals
Interpretation of the Probability Weighting Function
•• The effects of decision weights may counter the effects of the value function
•• Decision weights may promote general risk aversion
•• The probability weighting function requires specified outcomes and probabilities
•• Sensitivity to differences in probabilities varies with the level of probabilities
Organizational Applications
Level of Analysis
•• PT is an individual-level theory; whether it is homologous is debatable
•• It may be unclear who makes which decision in organizations
•• Perceptions likely vary across individuals and organizations
Alternative Explanations
•• Risk taking may reflect profit-maximizing behavior
•• Researchers must differentiate PT from other theories (see Table 2)
•• Preferences for immediate versus future outcomes shape risk taking
•• Costs of risk taking may influence behavior in ways not anticipated in PT
•• Organizational and cognitive biases influence choices
Ambiguous Reference Points
•• PT predictions depend heavily on the reference point
•• We need more evidence about which reference points are used and when
•• Research should specify the reference point, preferably ex ante
Risk-Taking Measures
•• Different measures of firm risk taking may capture different constructs
•• Firms may take several risks simultaneously
•• Risk-taking measures in management research may not align with PT
•• People perceive risk differently
and, to a lesser extent, reference points. Few studies drew on diminishing sensitivity.
However, studies incorporating the probability weighting function were virtually absent.
Table 3 includes some of the consequences of using PT partially.
We stress that the implications of ignoring aspects of PT are nontrivial. For example,
Levy and Levy (2002) claimed that their study participants made choices inconsistent with
PT. However, when calculating the value of the gambles the participants were evaluating,
Levy and Levy inserted probabilities in lieu of decision weights. Wakker (2003) recalculated
the value of the gambles using decision weights, as specified in PT (see Equation 2a above),
and he concluded that Levy and Levy’s data agreed fully with PT. Moreover, Bromiley
(2010) demonstrated that PT makes different predictions depending on whether scholars use
the value function alone, the probability weighting function alone, and/or both functions
together.
Therefore, if scholars do not use all of PT, they cannot readily argue that their results
either support or refute it. PT itself is a collection of concepts that were somewhat disjointed
before Kahneman and Tversky (1979) integrated them into a coherent theory (Wu, Zhang,
& Gonzalez, 2004). Thus, when scholars use some aspects of PT while not accounting for
others, they are not using PT. Rather, they are drawing on individual constructs and argu-
ments (e.g., the influence of loss aversion on choice), which may be useful but do not reflect
PT itself.
In this respect, we do not suggest that PT’s individual concepts cannot inform manage-
ment research. However, scholars must be clear whether they are deriving hypotheses from
PT itself or from a subset of its individual constructs. Absent the unifying framework PT
provides, scholars must also carefully explain how those constructs will shape the phenom-
ena of interest. Accordingly, we now discuss implications of the concepts embedded in PT’s
two central components: the value function and the probability weighting function.
Interpretations of the PT Value Function
In Table 3, we list four implications of the value function our review suggested were
either underutilized or misrepresented in management research. First, the curvature of the
value function is essential to PT (Tversky & Kahneman, 1981). Because the function is
nearly linear far from the reference point, risk seeking and risk aversion do not increase as
outcomes move further from the reference point. Rather, as we have emphasized, the value
function posits risk neutrality at large distances from the reference point.
Second, because PT assumes individuals evaluate outcomes by comparing them to a
reference point, past outcomes should not influence choice, beyond their possible effect on
the reference point. Some scholars have challenged PT’s assumption that choices do not
depend directly on past outcomes (Sitkin & Pablo, 1992), but it is fundamental to PT.
Specifically, it reflects PT’s isolation assumption: Individuals consider choices in isolation
rather than considering their impact on total wealth. In turn, concepts such as loss aversion
and diminishing sensitivity pertain to the subjective values of possible (i.e., future) gains and
losses. Although studies often operationalize the value function using historical (i.e., expe-
rienced) gains and losses, we emphasize that potential outcomes should be the focus of
research drawing on PT.
Third, many decisions in organizations constitute mixed gambles because both gains and
losses are possible. For example, most risky business choices (e.g., acquisitions or new
product introductions) can have positive or negative outcomes. Indeed, many managers
would not consider a choice risky unless it could have negative outcomes (March & Shapira,
1987). Although management theory applications of PT have largely ignored the implica-
tions of mixed gambles, they have important consequences for risk taking.
Importantly, the PT value function implies strong risk aversion for mixed gambles
(Bromiley, 2010). Tversky and Kahneman (1992: 316) argued that this risk aversion is due
to “[t]he pronounced asymmetry in the value function.” Specifically, in Figure 1, the kink
at the reference point produces a sharp difference between the subjective value of a gain and
the subjective value of an equivalent loss. This large kink exists because loss aversion
applies to negative outcomes, whereas it does not apply to positive ones (Bromiley, 2009).
In other words, the potential losses mean more to the individuals than the potential gains do.
If managers’ decisions often constitute mixed gambles yet scholars do not consider the
resulting risk aversion, results appearing to support PT actually may not do so. At the same
time, incorporating this PT prediction into our scholarship can enrich our understanding of
managers’ decisions and their implications.
Fourth, research should consider the possibility that the value function varies across indi-
viduals and firms. Although experimental studies have elicited functional forms and param-
eters that define the shape of the value functions for individuals (e.g., Abdellaoui, 2000;
Abdellaoui, Bleichrodt, & Paraschiv, 2007), these studies nearly always use monetary
gambles with university students. However, as Pennings and Smidts (2003) demonstrated,
we cannot assume that the parameters or shapes of the value function are the same for all
individuals. Thus, research needs to document value functions in organizations, determine
how to aggregate individuals’ value functions up to the level of the firm, and identify the
conditions under which such aggregation is warranted (e.g., G. Chen, Mathieu, & Bliese,
2004; Klein, Dansereau, & Hall, 1994).
The parameters or shape of the value function should also vary systematically across
firms. For example, losses that appear immense for small businesses may appear trivial for
many large firms. Likewise, it seems quite problematic to assume all firms view potential
risks the same way. This possibility addresses boundary conditions for PT, as Kahneman and
Tversky (1979) cautioned that the PT value function may not accurately predict choices
involving either ruinous or insignificant losses.
Interpretations of the PT Probability Weighting Function
In light of our earlier conclusion that management research frequently ignores decision
weights, Table 3 emphasizes four aspects of the probability weighting function future man-
agement research should consider.
First, although management scholars often attribute PT’s predictions about risk taking to
loss aversion, Kahneman and Tversky (1979: 280) argued that “decision weights could pro-
duce risk aversion and risk seeking” even without loss aversion. To illustrate, consider a
choice between either $5 with certainty or a gamble with a 50% probability of $0 and a 50%
probability of $10. The underweighting of the probabilities (see Figure 2) reduces the value
of the gamble (e.g., see Equations 2a and 2b) below its expected value, resulting in a prefer-
ence for the certain outcome (i.e., $5 for sure). Thus, the probability weighting function
produces risk aversion in this example. Alternatively, if the same gamble involved losses, the
underweighting of probabilities would make the value of the gamble greater than its (nega-
tive) expected value. According to PT, individuals would then prefer the gamble, evidencing
risk seeking. Thus, in these examples, loss aversion (from the value function) is not neces-
sary to generate the “risk averse above; risk seeking below” prediction scholars often attri-
bute to PT.
Importantly, the probability weighting function’s decision weights can also generate the
opposite prediction. The probability weighting function suggests that individuals overweight
low probabilities (see Figure 2). When the decision weight is larger than the probability, the
value of gambles involving gains can exceed the expected value, and the value of gambles
involving losses can be below the (negative) expected value (e.g., see Equation 2a and 2b).
By extension, due to the overweighting of low probabilities, individuals may be willing to
accept low-probability gambles involving gains but avoid such gambles involving losses.
Thus, PT predicts that individuals can exhibit a fourfold pattern of risk taking: “risk aver-
sion for gains and risk seeking for losses of high probability; risk seeking for gains and risk
aversion for losses of low probability” (Tversky & Kahneman, 1992: 297). Perhaps owing
to the general tendency to ignore the probability weighting function, however, we found no
management theory applications of PT incorporating this prediction. This omission limits
our ability to explain commonly observed phenomena using PT. For example, risk-seeking
behavior for low-probability gains explains the popularity of lotteries, and risk-averse
behavior for low-probability losses explains the prevalence of insurance against catastrophic
yet unlikely phenomena (Kahneman & Tversky, 1979). Likewise, managers face some
choices that involve extremely high probabilities (e.g., production cost savings from new
equipment) and extremely low probabilities (e.g., developing a new drug). Thus, considering
PT’s fourfold pattern of risk taking provides a new lens through which to examine many
managerial decisions.
Second, the fourfold pattern notwithstanding, the probability weighting function also
contributes to a general pattern of risk aversion for many choices. Figure 2 reveals that most
probabilities are underweighted. By extension, even though the probabilities of all possible
outcomes in a gamble obviously sum to one, the decision weights for all of the possible
outcomes of a risky choice will often sum to less than one (Kahneman & Tversky, 1979).
That the decision weights typically sum to less than one contributes to a general tendency
toward risk aversion. Management research drawing on PT has ignored this general pattern
of risk aversion the probability weighting function frequently implies.13
Third, the importance of the probability weighting function poses challenges to manage-
ment researchers. Although experimental studies can apply it by providing outcomes and
probabilities to participants, researchers conducting field studies must identify the outcomes
managers are considering and must develop reasonable estimates of the probabilities manag-
ers assign to such outcomes. Moreover, if researchers wish to utilize the probability weight-
ing function CPT implies, they must be able to identify which outcomes managers perceive
as gains and which ones managers perceive as losses, because the relations between prob-
abilities and decision weights are different for gains and losses (see Figure 2). Thus, the
difficulties of properly representing outcomes and probabilities may be insurmountable in
many areas of management research.
However, using the probability weighting function might be plausible in some situations.
For example, researchers examining well-defined CEO incentives might be able to make
plausible assumptions about the probabilities of potential outcomes. Furthermore, if there
are rich data specifying the outcomes of past decisions and it is plausible managers consider
such data, scholars may be able to infer the influence of probabilities on managerial choices.
Likewise, the argument that individuals infer probabilities is evident in Sine, Haveman, and
Tolbert’s (2005) study of the effects of external institutions on firm founding rates and in
Steel and Konig’s (2006) illustration that CPT can enrich theories of motivation.
Fourth, the shape of the probability weighting function implies that managers’ sensitivi-
ties to differences in probabilities vary. For probabilities near 50%, for example, the nearly
horizontal slope of the probability weighting function (see Figure 2) implies that “people are
relatively insensitive to probability difference[s]” (Tversky & Kahneman, 1992: 312).
However, note the sharp increase in the slopes near 0% and 100%. In this region, slight
differences in probabilities lead to dramatic differences in decision weights. Thus, there is a
need to understand how individuals infer probabilities (see J. E. Smith & von Winterfeldt,
2004, for a review of the vast literature on how individuals infer probabilities).
Using PT in Organizational Settings
We now turn to issues specifically associated with applying PT outside experimental set-
tings. Our purpose is not to discourage researchers from using PT outside of the lab. Rather,
it is to note the challenges in such applications in the hopes of encouraging richer use of PT.
Herein, we discuss issues related to (a) levels of analysis, (b) accounting for alternative
explanations in empirical work, (c) identifying reference points, and (d) measuring risk
taking. Again, we summarize this discussion in Table 3.
Level of analysis. As our review demonstrated, applying PT to complex, multilevel orga-

nizational settings can present several theoretical and methodological challenges. In our
view, many studies using PT at higher levels implicitly use it as a homologous theory. In
other words, they assume its constructs have the same meanings and relations across levels
(G. Chen, Bliese, & Mathieu, 2005). As Table 3 suggests, PT may not be as homologous as
many scholars assume.
For example, in organizations, it may be unclear who makes the decisions researchers
examine. Many studies attempt to minimize this concern by focusing on the CEO, but other
top- (Hambrick, 1994) and middle-level managers (Kuratko, Ireland, Covin, & Hornsby,
2005) influence decisions as well. As our review of studies at the individual level showed,
there are several reasons why these individuals might interpret decisions differently.
Depending on their location and job, for example, managers attend to different immediate
concerns (Lawrence & Lorsch, 1967) and have different access to information (Thompson,
1967). Therefore, it is unlikely that all organizational members perceive potential outcomes
and probabilities similarly. The possibility that some individuals do not have value functions
and probability weighting functions resembling those in Figures 1 and 2 produces additional
complexity (Abdellaoui, 2000; Bleichrodt & Pinto, 2000; Pennings & Smidts, 2003).
Given these sources of variation, generalizing PT’s predictions about individual-level
behavior to draw conclusions about the behavior of firms increases the potential for cross-
level fallacies (e.g., Rousseau, 1985). Consistent with arguments offered by others (Hitt,
Beamish, Jackson, & Mathieu, 2007; Klein et al., 1994), to test PT definitively in organiza-
tional settings, scholars must identify the appropriate decision makers and account for the
possibility that they interpret decisions differently (Bromiley, Miller, & Rau, 2001; Svenson,
1996). Likewise, scholars need to consider alternative explanations for their findings. We
now turn to this issue.
Alternative explanations. Scholars who use PT in organizational settings should recog-

nize, and preferably account for, alternative explanations for evidence that appears to support
PT. Table 3 includes five such alternative explanations.
First, scholars should consider the possibility that managers are simply acting sensibly to
achieve their personal or organizational goals. For example, if managers believe a risky
behavior will increase performance, an empirical study finding that low-performing firms
enacted the behavior more than did high-performing firms would not necessarily support PT.
Rather, it is plausible that managers in the low-performing firms felt more pressure to
improve performance, and so took an action expected to do so.
Thus, to claim a purely PT-based explanation for risk taking, scholars need evidence that
the behaviors observed are incompatible with either managers’ goals or those of the organi-
zation. For example, in a product pricing experiment, Ho and Zhang (2008) found that the
risk-seeking behaviors of loss-frame individuals reduced their performance in a hypothetical
task. The finding that the behaviors were inconsistent with performance-maximizing behav-
ior bolstered the authors’ conclusion that the behaviors reflected risk-seeking preferences.
Often, experiments using PT account for profit-seeking behavior by equating the expected
values of the available gambles. For example, Miller and Shapira (2004) examined the prices
individuals set when buying and selling call and put options, which provide rights to buy and
sell assets (respectively) at a given exercise price. Arguing that call (put) options create gain
(loss) frames, they found that individuals’ pricing of call options evidenced risk aversion and
individuals’ pricing of put options evidenced risk seeking. These pricing decisions were
inconsistent with the expected values of the options, thereby bolstering Miller and Shapira’s
(2004) conclusion that the results reflected the individuals’ risk-taking preferences.
Second, researchers need to differentiate between PT and the BTOF. Table 2 and our
earlier discussion suggest that the two theories make distinct predictions. However, to dif-
ferentiate the two theories, scholars will need to derive their predictions more directly and
rigorously from the theories themselves.
Third, in organizational settings, managers likely expect that the outcomes of many deci-
sions involving risk will not occur immediately after the choice. Thus, in addition to PT
explanations, researchers must account for the possibility that individuals’ preferences for
immediate outcomes and those that will occur in the distant future likely vary (Shelley, 1993;
Thaler, 1981).
Fourth, whereas risk-taking decisions in experiments generally involve no added cost, risk
taking in organizations requires resources. For example, Voss, Sirdeshmukh, and Voss (2008)
found evidence that risk-seeking managers invest more in exploration than exploitation, but
only when their organizations had sufficient financial slack to support exploration. Likewise,
Chattopadhyay et al.’s (2001) study that we reviewed earlier found that risk-seeking behavior
is more likely when organizations have the financial resources to fund it. Thus, researchers
applying PT in organizational settings must account for the cost to implement risk-averse or
risk-seeking decisions.
Fifth, scholars must differentiate PT predictions from the effects of known organizational
and cognitive biases. Whereas the experiments on which Kahneman and Tversky (1979)
based PT provided clear explanations of outcomes and their probabilities, in organizations,
the specification of outcomes and their probabilities depend on organizational processes.
Thus, individuals’ perceptions of the outcomes and probabilities may incorporate a variety
of biases and other issues associated with both individual and organizational information
processing. For example, March and Simon (1958) noted that retransmissions of information
may reduce uncertainty about that information, a phenomenon termed uncertainty absorp-
tion. Likewise, Bromiley (1987) documented numerous systematic biases in different kinds
of organizational forecasts. While marketers proposing a new product may tend to optimistic
forecasts, for example, sales people whose incentives tie to forecasts may tend to conservative
forecasts.
Regarding cognitive biases, loss aversion can help explain the tendency to continue tasks
once investments are made (i.e., escalating commitment; Arkes & Blumer, 1985; Brockner,
1992), preferences for the current state of affairs (i.e., the status quo bias; Kahneman,
Knetsch, & Thaler, 1991; Samuelson & Zeckhauser, 1988), and the reluctance to relinquish
possessed goods (i.e., endowment; Kahneman, Knetsch, & Thaler, 1990; Tversky &
Kahneman, 1991). Thus, scholars need to consider whether such cognitive biases are mani-
festations of loss aversion or are independent constructs that are related to loss aversion.
More broadly, scholars should be aware that these cognitive biases can confound empirical
tests of PT.
As this discussion implies, scholars must contend with several confounds when testing
PT. When applying PT in organizational settings, additional concerns related to the measure-
ment of important constructs also emerge, as we now illustrate.
Ambiguous reference points. Our review demonstrates that management scholars fre-
quently draw on PT to argue that individuals or firms behave differently when outcomes are
above versus below a reference point. Moreover, gains and losses with identical probabilities
have different decision weights in CPT (see Figure 2). Thus, as Table 3 suggests, identifying
the reference point is critical.
Given PT’s experimental roots, wherein researchers manipulated reference points, little
guidance exists about how to identify and measure them in nonexperimental settings.
Scholars have noted the plethora of reference points used in both individual-level (Kahneman,
1992) and organizational-level (Fiegenbaum et al., 1996) research. Thus, there is a need for
more precise knowledge about the origins of reference points, especially when we seek to
generalize experimental findings to settings outside the lab (e.g., Fischhoff, 1996; Short &
Palmer, 2003; Svenson, 1996).
For example, without knowing when individuals or firms are likely to use one reference
point versus another, PT can be difficult to falsify in organizational settings. Illustrating this
concern, Fiegenbaum et al. (1996: 223) noted that in field research, “any variable(s) that
highlights a particular target or objective seems capable of establishing a reference point.”
Thus, results counter to PT could mean that the researcher assumed a different reference
point than the decision maker used. Alternately, they could mean that the researcher used the
correct reference point but PT was not predictive.
Researchers may need to collect a variety of objective and subjective data to understand
which reference points individuals and organizations use (Fiegenbaum et al., 1996). Indeed,
exclusive reliance on archival data implicitly assumes that managers interpret a decision the
way researchers interpret it (e.g., Short & Palmer, 2003). Ironically, however, the notion of
framing continues to demonstrate how and why individuals interpret decisions differently.
Thus, “[t]o get a sense of how subjects are reasoning, it is useful to let them speak for
themselves” (Lopes, 1996: 184). For example, Devers, Wiseman, et al. (2007) used a ques-
tionnaire to verify how study participants interpreted and used the information they were
given. Furthermore, scholars could use content analyses of company reports to identify the
reference points firms are utilizing (Short & Palmer, 2003). Despite the dangers of desir-
ability and self-serving biases (Short & Palmer, 2003), such qualitative data can help
specification and reduce the possibility that researchers attribute outcomes to incorrect
causes. Moreover, longitudinal, repeated measures research designs may provide insights
into how decision makers alter their selection of reference points over time, thereby helping
us move beyond the static choices that has often characterized PT-based research
(Hollenbeck, Ilgen, Phillips, & Hedlund, 1994; Slattery & Ganster, 2002). We also encour-
age the use of other underused approaches to studying decision making, including case study
techniques, quasi-experiments, field experiments, and surveys.
Furthermore, we encourage additional work along the lines of the aforementioned
Pennings and Smidts (2003) study, which estimated participants’ value functions and used
them to study attributes of the individuals’ organizations. More broadly, we urge scholars to
identify reference points ex ante, especially when conducting research at higher levels of
aggregation. If possible, scholars should also test their models with alternate assumptions
about the reference point decision makers utilize.
Risk-taking measures. In many experiments testing PT, one of the available gambles is
certain, often making the risky option (i.e., the probabilistic one) readily apparent. Although
risk has a well-defined meaning in such a simple experiment, it has numerous, different
meanings in organizations. For example, the risks confronting managers (e.g., the possibility
of termination) sometimes depart from those confronting organizations (e.g., Palmer &
Wiseman, 1999). Furthermore, different firm-level measures of risk often capture different
constructs (e.g., Miller & Bromiley, 1990).
Firms may also take several risks simultaneously (Kahneman & Lovallo, 1993).
Sometimes, one source of risk may exacerbate another. Wiseman and Catanach (1997), for
example, found that financial firms paying more to access funding (i.e., interest rate risk)
could also be at a higher risk of defaulting on other liabilities (i.e., liquidity risk). At other
times, however, risk-seeking behavior in some activites may counterbalance risk-averse
behavior in others (McNamara, Moon, & Bromiley, 2002). To illustrate, Gomez-Mejia,
Haynes, Nunez-Nickel, Jacobson, and Moyano-Fuentes (2007) demonstrated that founding
families accept a higher risk of firm failure in an effort to preserve family control, yet they also
minimize performance variability to avoid exacerbating this risk. However, if firms are behav-
ing in accordance with the isolation assumption of PT, they should address risky decisions
sequentially (i.e., one at a time) rather than trading off one form of risk for other forms of risk.
Moreover, we emphasize that people have different beliefs about what is risky (Bromiley
& Curley, 1992; Kühberger, 1998; Sitkin & Weingart, 1995; Weber & Milliman, 1997).
Perhaps because of such variation, as our review showed, some researchers use a given
behavior (e.g., a divestiture) to measure risk aversion, whereas other researchers use that
behavior to measure risk seeking. Therefore, scholars should take greater care in defining,
ex ante, what constitutes risk-averse and risk-seeking choices. Furthermore, when possible,
scholars should examine the construct validity of their risk measures.
We also suggest that management scholars shift some attention away from exclusive reli-
ance on secondary data and toward primary field data capable of capturing executives’ per-
ceptions of risk in actual organizational environments and situations. For example, we are
encouraged by Larraza-Kintana et al.’s (2007) approach to measuring risk taking. These
scholars had CEOs assess (a) how frequently their firms engaged in nine strategic actions
and (b) the risk associated with each of the nine actions. In turn, these scholars captured risk
taking at the organizational level as a weighted average of the frequency with which the
CEO’s firm used those actions and their perceived riskiness to him or her. This approach
helps to ensure that the measures scholars use to capture risk accurately reflect managers’
perceptions of that risk. Scholars could use a similar approach to distinguish different forms
of risk taking. Such measures have construct validity and, thus, could advance the state of
PT research in management (e.g., Boyd, Gove, & Hitt, 2005).
Conclusion
Management studies drawing on PT have made valuable contributions in diverse research

streams, including executive compensation, negotiations, affect and motivation, HRM, rela-
tions between organizational risk and return, and firm risk-taking behaviors. Thus, we urge
scholars to continue drawing on PT in the future.
However, management scholars have yet to realize the full potential of PT. In particular,
management studies typically draw predictions from only one of PT’s two central compo-
nents. In addition, some research uses PT in ways inconsistent with the theory. Therefore, it
remains unclear whether this body of management research definitively supports PT. Given
this concern, we stress that scholars using PT should draw their predictions directly from
both components of the theory. In this respect, we have offered suggestions to aid scholars
seeking to use PT more precisely and comprehensively.
In addition, we provided guidance to enrich the use of PT in organizational settings.
Specifically, researchers should exercise caution when applying PT at higher levels of aggre-
gation. They should also consider several alternative explanations for findings that appear to
support PT. In addition, while emphasizing the importance of understanding the reference
points decision makers use, we also suggested how researchers can study reference points
more thoroughly in the future. Finally, we noted challenges in measuring risk taking in orga-
nizational settings and highlighted approaches we believe can enhance the quality of future
work in this regard.
In short, we are excited about the contributions management theory applications of PT
have made, and we hope our work will be a catalyst for additional, yet more precise and
consistent, use of PT in the future.
Notes
1. We selected the following journals: Academy of Management Journal, Academy of Management Review,
Administrative Science Quarterly, Human Resource Management, Journal of Applied Psychology, Journal of
Management, Journal of Management Studies, Journal of Organizational Behavior, Management Science,
Organization Science, Organizational Behavior and Human Decision Processes, Personnel Psychology, and
Strategic Management Journal. We also used this list of journals to identify articles to review.
2. For simplicity, we use the term outcome(s) in lieu of the term potential outcome(s) for the remainder of the
article, unless we are drawing specific attention to the difference between potential and historical (i.e., experienced)
outcomes.
3. Figure 1 is based on functional forms and parameters from Tversky and Kahneman (1992).
4. To understand why the curvature of the value function reflects risk-taking preferences, consider a gamble
with two equally probable outcomes of $0 and –$20. The expected value of the gamble is –$10. The total value of
this gamble will be a weighted sum of the subjective value of 0 and the subjective value of –20, and so will fall on
a line joining these two subjective values (depending on the probabilities). If the value function is convex, then the
subjective value of –$10 will be below the line joining the subjective values of 0 and –20. Because the subjective
value of the gamble is greater than the subjective value of –$10, the individual will prefer the gamble, thereby
illustrating risk seeking. A symmetric argument provides risk aversion above the reference point.
5. Figure 2 is based on functional forms and parameters from Tversky and Kahneman (1992).
6. In this respect, many experimental tests of prospect theory (PT) implicitly demonstrate that people’s risk-
taking preferences are inconsistent with conventional notions of rationality, according to which such preferences
should not vary when individuals receive identical information in slightly different ways (Tversky, Slovic, &
Kahneman, 1990).
7. We thank an anonymous reviewer for encouraging us to highlight this distinction.
8. Of the 28 articles that we identified in this step, 6 of them were already in our sample, and 5 of the articles
were entrepreneurship articles, which we eliminated. Therefore, we added 17 articles to our sample. We thank an
anonymous reviewer for encouraging us to identify some of the most influential articles drawing on PT.
9. Devers, Wiseman, and Holmes (2007) attempted to minimize the possibility that differences in the objective
values of the stock options accounted for their results. For example, in the gain frame, the Black–Scholes value was
higher for the high-volatility stock than for the low-volatility stock. However, in that same frame, the subjective
values assigned by the study participants were higher for the low-volatility stock than for the high-volatility stock.
We thank an anonymous reviewer for encouraging us to clarify this issue.
10. Tversky and Kahneman (1991) estimated the displeasure of losses to be more than twice the pleasure of
equivalent gains. Subsequent studies have supported this assertion (Bleichrodt, Pinto, & Wakker, 2001; Tversky &
Kahneman, 1992).
11. There are several methodological debates surrounding the statistical techniques and measures used to study
relations between organizational risk and return. Some of these debates, while important, do not pertain directly to
PT itself. Therefore, we refer interested readers to Andersen, Denrell, and Bettis, (2007), Baucus, Golec, and
Cooper (1993), Bromiley (1991a), Bromiley and Rau (2010), Henkel (2009), Ruefli (1990), and Wiseman and
Bromiley (1991).
12. The studies we include in the section reviewing research on executive compensation consider dependent
variables at the individual level. Here, we consider dependent variables at the firm level.
13. The amount of risk aversion varies depending on the parameters in the probability weighting function as
well as those of the value function (Blavatskyy, 2005; Bromiley, 2010).
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Management Theory Applications of Prospect

An Introduction to Prospect Theory

The Historical Context of PT

Expected utility (gamble) = ∑Ni= 1 u (i) ∗ p(i), (1)

Value of a Gamble = n (y) + p (p) ∗ [n (x) - n (y)], (2b)

Importantly, as Equations 2a and 2b illustrate, PT is primarily concerned with individuals’

The PT probability weighting function. The probability weighting function converts a

Panel A. Probability weighting function for gains

Panel B. Probability weighting function for losses

Distinguishing PT from the BTOF

Identifying PT Research in Management

Management Theory Applications of PT at the Individual Level

In this section, we review management theory applications of PT at the individual level.

Affect and Motivation

Management Theory Applications of PT

Although it is an individual-level theory, scholars often apply PT to explain higher-level

Organizational Risk and Return

Early applications of PT in the management literature examined relations between orga-

Firm Risk-Taking Behaviors

Individual-level antecedents of firm risk-taking behaviors. Amit and Schoemaker (1993)

An Analysis of Management Theory Applications

As our review demonstrated, management research drawing on PT typically considers

Interpretations of the PT Value Function

Interpretations of the PT Probability Weighting Function

Using PT in Organizational Settings

Level of analysis. As our review demonstrated, applying PT to complex, multilevel orga-

Alternative explanations. Scholars who use PT in organizational settings should recog-

Management studies drawing on PT have made valuable contributions in diverse research

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