https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf

Theory of the firm: Managerial behavior, agency costs and ownership structure

This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob- abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling. EXPECTED UTILITY THEORY has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (24), and widely applied as a descriptive model of economic behavior, e.g. (15, 4). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (47, 36), and that most people actually do, most of the time. The present paper describes several classes of choice problems in which preferences systematically violate the axioms of expected utility theory. In the light of these observations we argue that utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model and we propose an alternative account of choice under risk. 2. CRITIQUE

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Prospect theory: an analysis of decision under risk

In this paper, we argue that the ability of a firm to recognize the value of new, external information, assimilate it, and apply it to commercial ends is critical to its innovative capabilities. We label this capability a firm's absorptive capacity and suggest that it is largely a function of the firm's level of prior related knowledge. The discussion focuses first on the cognitive basis for an individual's absorptive capacity including, in particular, prior related knowledge and diversity of background. We then characterize the factors that influence absorptive capacity at the organizational level, how an organization's absorptive capacity differs from that of its individual members, and the role of diversity of expertise within an organization. We argue that the development of absorptive capacity, and, in turn, innovative performance are history- or path-dependent and argue how lack of investment in an area of expertise early on may foreclose the future development of a technical capability in that area. We formulate a model of firm investment in research and development (R&D), in which R&D contributes to a firm's absorptive capacity, and test predictions relating a firm's investment in R&D to the knowledge underlying technical change within an industry. Discussion focuses on the implications of absorptive capacity for the analysis of other related innovative activities, including basic research, the adoption and diffusion of innovations, and decisions to participate in cooperative R&D ventures. **

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Absorptive capacity: a new perspective on learning and innovation

The dynamic capabilities framework analyzes the sources and methods of wealth creation and capture by private enterprise firms operating in environments of rapid technological change. The competitive advantage of firms is seen as resting on distinctive processes (ways of coordinating and combining), shaped by the firm's (specific) asset positions (such as the firm's portfolio of difftcult-to- trade knowledge assets and complementary assets), and the evolution path(s) it has aflopted or inherited. The importance of path dependencies is amplified where conditions of increasing retums exist. Whether and how a firm's competitive advantage is eroded depends on the stability of market demand, and the ease of replicability (expanding intemally) and imitatability (replication by competitors). If correct, the framework suggests that private wealth creation in regimes of rapid technological change depends in large measure on honing intemal technological, organizational, and managerial processes inside the firm. In short, identifying new opportunities and organizing effectively and efficiently to embrace them are generally more fundamental to private wealth creation than is strategizing, if by strategizing one means engaging in business conduct that keeps competitors off balance, raises rival's costs, and excludes new entrants. © 1997 by John Wiley & Sons, Ltd.

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Dynamic capabilities and strategic management

Measuring the efficiency of decision making units

Introduction It is intended here to offer a possible characterization of the concept of complete ignorance. Like other formulations, the problem is taken to be that of choice of an action from a given set when the consequences of any action are functions of an unknown state of nature. However, the properties regarded as defining an optimal choice are designed to reflect completely the idea that there is no a priori information available which gives any state of nature a distinguished position. Most importantly, the optimality criterion differs from those in the now more standard subjective probability framework by not presupposing a fixed list of states of nature. As we note shortly, the arguments and conclusions are much closer to Shackle's than to those of Ramsey, de Finetti, and Savage. The axiom systems of these last authors imply the existence of subjective probabilities as weights to be assigned to the different possible states of nature. These authors thus provide a foundation for the centuries-old use of probability as a guide to action. The concept of complete ignorance can be expressed in this subjective probability framework only by the assignment of equal probabilities to all the states of nature, which is the principle of indifference or insufficient reason implicit in the earliest combinatorial probability calculations of Pascal and Fermat and explicit in Jacob Bernoulli, Bayes, and Laplace.

Studies in Resource Allocation Processes: Appendix: An optimality criterion for decision-making under ignorance

Publisher Summary A very widespread economic situation is that of the relation between a principal and an agent. Even in ordinary and in legal discourse, the principal–agent relation is significant in scope and economic magnitude. The chapter discusses that the common element is the presence of two individuals. One is to choose an action among a number of alternative possibilities. The action affects the welfare of the other, the principal, as well as that of the agent's self. The principal, at least in the simplest cases, has the additional function of prescribing payoff rules—that is, of determining in advance of the choice of action, a rule that obliges him or her as to what fee to pay as a function of his or her observations on the results of the action. The problem acquires interest only when there is uncertainty at some point, and, in particular, when the information available to the two participants is unequal. In technical language, the outcome is a random variable whose distribution depends on the action taken. The principal–agent theory is in the standard economic tradition. Both principal and agent are assumed to be making their decisions optimally in view of their constraints. Intended transactions are realized. The function of this theory has the dual aspect usual in economic theory; it can be interpreted both normatively and descriptively. It can also be interpreted as an attempt to explain observed phenomena in the empirical economic world, particularly exchange relations that are observed but not explained by more standard economic theory.

Chapter 23 Agency and the market

http://www.dtic.mil/cgi-bin/GetTRDoc?AD=AD0220502&Location=U2&doc=GetTRDoc.pdf

Competitive stability under weak gross substitutability: the euclidean distance approach

Technical Information and Industrial Structure

1. Homogeneous Systems in Mathematical Economics: A Comment 2. Alternative Approaches to the Theory of Choice in Risk-Taking Situations 3. The Determination of Many-Commodity Preference Scales by Two-Commodity Comparisons 4. Utilities, Attitudes, Choices: A Review Note 5. The Measurement of Price Changes 6. Rational Choice Functions and Orderings 7. Additive Logarithmic Demand Functions and the Slutsky Relations 8. Utility and Expectation in Economic Behavior 9. The Theory of Risk Aversion 10. Exposition of the Theory of Choice under Uncertainty 11. The Use of Unbounded Utility Functions in Expected-Utility Maximization: Response 12. Optimal Insurance and Generalized Deductibles 13. Risk Perception in Psychology and Economics Index

Kenneth J. Arrow

Papers

Studies in Resource Allocation Processes: Appendix: An optimality criterion for decision-making under ignorance

Chapter 23 Agency and the market

Competitive stability under weak gross substitutability: the euclidean distance approach

Technical Information and Industrial Structure

Individual choice under certainty and uncertainty