Prospect Theory, Risk and Innovation

By: Jeffrey Baumgartner

Start-up companies are almost synonymous with innovation, while the well established companies are usually perceived as being risk averse and much less innovative. In this article Jeffrey Baumgartner uses Prospect Theory to better understand how executives perceive risk and innovation opportunities.

Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. It describes how people make decisions around economic risk and is particularly interesting as it demonstrates that people often do not interpret risk rationally, at least in economic terms. In particular, prospect theory shows that people are highly risk averse when it comes to potentially increasing their wealth, but risk seeking when dealing with potential economic loss. Moreover, there is a tendency for the average person to look at losses and gains in percentages rather than absolute terms. For example, a consumer will drive across town to save $5 on a $15 dollar appliance; but cannot be bothered to go out of her way to save $5 on a $125 appliance. In both cases, the absolute saving is the same. However, in the first example, it is one third of the cost of the product; whereas in the second example, it is only 4%.

Prospect theory would seem also to be applicable to innovation and, indeed, shows that start-ups are likely to be more risk-seeking, and hence innovative, than established companies. A situation we know is generally the case.

Prospect theory started as a thought experiment which was backed up by substantial testing. It is widely accepted by economists today and even earned Kehneman a nobel prize. Tversky, sadly, died before he could share it.

The reflection effect

Kahneman and Tversky found that if a group of people is offered the choice between:

a) A 100% chance of receiving $3000.
b) An 80% chance of receiving $4000, but a 20% chance of receiving nothing.

About 80% of the subjects will choose option (a). In other words, when it comes to making money, the average person prefers a guaranteed gain rather than gamble on the possibility of winning a greater amount of money but with a threat of getting nothing.

However, when given a very similar choice:

c) A 100% chance of losing $3000.
d) An 80% chance of losing $4000, but a 20% chance of losing nothing.

Some 92% of the subjects will choose option (d). In other words, they would rather risk losing more money with a small chance of not losing anything.

From a logical perspective, of course, this does not make sense. Assuming people are using the same internal maths to evaluate the risk in both cases, we should see similar results. But of course humans are not logical. Moreover, most people are extremely poor at evaluating risk and especially threats.

Risk and innovation

The implementation of a potentially innovative idea in a business inevitably involves risk. Broadly speaking, the more innovative an idea is, the greater the risk. That’s because highly innovative ideas are by definition very different to the current situation (be it a product, service or process). Thus its success cannot easily be measured against existing cases. As a result, the more innovative an idea is, the harder it is to determine the result of its implementation. Let’s call this Baumgartner’s Axiom of Innovative Risk!

An established business in normal times (i.e., not during an economic recession) usually generates a continuous and most likely slowly increasing income. Thus, when faced with diverting resources to implement an innovative idea, the manager is faced with a choice similar to (a) and (b) above. She can either not implement the idea and stay with the effectively guaranteed slowly increasing income (option a) or she can gamble by diverting resources and budget to implement the potentially innovative idea (option b) which offers an indeterminate likelihood of generating significantly more income than in the past and an equally indeterminate possibility of earning no income.

Not surprisingly, most managers opt for option (a). They avoid implementing the innovative idea and avoid its potential risk.

A typical start-up company, on the other hand, begins its existence losing money. Capital is invested in salaries, equipment, raw materials, etc. But from the moment the start-up begins operations, money is disappearing. Usually it takes one or more years before a start-up generates more income than it losses.

Thus a manager deciding whether or not to implement a potentially innovative idea is faced with a choice similar to (c) and (d) above. Not implementing the idea will result in a continued and predictable loss of income (option c). Implementing the idea, which may require additional resources, however, may result in a greater loss – if the idea does not succeed – or a reduced loss or even a profit if it succeeds (option d).

Risk in start-ups vs. established companies

And indeed, start-up companies are almost synonymous with innovation, whereas well established companies are usually perceived as being risk averse and much less innovative. Indeed, in a medium to large established firm, the most effective form of innovation seems to be to buy a smaller, innovative firm!

Of course there are exceptions. Established companies do periodically launch innovative new products and services. They sometimes develop innovative new operational processes. But prospect theory states that a percentage of people will go against the masses and take on risk, in effect gambling that an opportunity will result in increased income.

Innovation in loss-making companies

Interestingly, another area where we often see potentially innovative ideas being implemented is in companies facing serious financial problems. Both General Motors and Chrysler, two American car companies, are in serious financial difficulty. In order to avoid bankruptcy, and on orders of the President of the United States, both came up with business plans far more innovative than anything either company has done in recent decades.

This fits within prospect theory. Faced with losing money (in this case everything) or taking risk in order to reduce that loss (ideally to no loss), the average person will take the second option. This is precisely what the managers at the two companies have opted to do.

Enron was a highly innovative company in its final years. It could trace its roots back to 1932 and for much of its history was a nondescript natural gas and electricity supplier. A number of mergers later and the company became Enron, a company which Fortune magazine called America’s most innovative every year from 1996 to 2001. And Enron was innovative, both in terms of financial mismanagement as well as in terms of innovative products and services.

And, again, that follows with prospect theory. As Enron’s management realized that the company was actually losing vast sums of money (rather than earning cash by the sackful as their financial statements claimed), it makes sense that the managers implemented risky, potentially innovative ideas in hopes of winning a gamble that would take the company from losing lots of money to breaking even or earning an income.

Of course that never happened at Enron. The company went spectacularly bankrupt in late 2001.

Lessons to be learned from prospect theory

Prospect theory, when applied to innovation, suggests that managers in profitable companies are likely to be risk averse and therefore are psychologically likely to reject potentially innovative ideas, particularly new product and service ideas that offer an opportunity to increase income. However, potentially innovative ideas which reduce loss, are more likely to be implemented. Thus, in an established firm, process efficiency ideas, which reduce costs, are more attractive to the typical human than are product ideas. And this is true in my experience, anyway.

Likewise, loss making companies such as new start-ups or companies facing economic difficulties are more likely to embrace new product and service ideas as they offer the opportunity to reduce loss. However, start- ups with a young not-yet-defined corporate culture would seem more likely to innovate effectively than established companies that are suddenly losing money and need to innovate themselves out of trouble.

By Jeffrey Baumgartner

References

“Prospect Theory”, Wikipedia
http://en.wikipedia.org/wiki/Prospect_theory

“An Introduction to Prospect Theory”, Econoport
http://www.econport.org/econport/request?page=man_ru_advanced_prospect

“Kahneman and Tversky’s Prospect Theory”, San José State University Economics Department web site
http://www.sjsu.edu/faculty/watkins/prospect.htm

Enron Anatomy of Greed, 2002, Brian Cruver, Arrow Books.

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