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.

/pdf/dynamic-capabilities-and-strategic-management-4iyi34iyh6.pdf

Dynamic capabilities and strategic management

Measuring the efficiency of decision making units

Publisher Summary This chapter discusses stability independent of adjustment speed. Hicks, in his classic work, introduced for serious consideration by economists the problem of analyzing stability in multiple markets. He defined a concept of perfect stability in which one market was singled out and the remaining markets were divided into two sets: in the first set, all prices were held fixed at their equilibrium values, while, as the singled-out price varied, all prices in the second set were continuously adjusted to keep supply and demand on all the markets in that set constant. Under these conditions, excess demand was defined as a function of the singled-out price. If the resulting function was downward sloping for all ways of singling out a price and all ways of dividing the remaining markets into two sets as indicated, then the economy was said to be perfectly stable. A necessary and sufficient condition for perfect stability was that the Jacobian matrix of the excess demand functions have the property that the principal minors of odd order have negative determinants and those of even order have positive determinants.

Stability independent of adjustment speed

Costs of carbon emissions are being underestimated, but current estimates are still valuable for setting mitigation policy.

Improve Economic Models of Climate Change

Issues in Contemporary Economics

The Economy as an Evolving Complex System: The Proceedings of the Evolutionary Paths of the Global Economy Workshop

Decision theory, as it has grown up in recent years, is a formalization of the problems involved in making optimal choices In a certain sense---a very abstract sense, to be sure---it incorporates operations research, theoretical economics, and wide areas of statistics, among others The formal structure of a decision problem in any area can be put into four parts: 1 the choice of an objective function defining the relative desirability of different outcomes, 2 specification of the policy alternatives which are available to the agent, or decisionmaker, 3 specification of the model, that is, empirical relations that link the objective function, or the variables that enter into it, with the policy alternatives and possibly other variables, and 4 computational methods for choosing among the policy alternatives that one which performs best as measured by the objective function In the last part, the objective function is maximized subject to the constraints imposed by the model It is for this reason that decision theory is mathematically, to a great extent, a branch of the theory of constrained maxima

Kenneth J. Arrow

Papers

Stability independent of adjustment speed

Improve Economic Models of Climate Change

Issues in Contemporary Economics

The Economy as an Evolving Complex System: The Proceedings of the Evolutionary Paths of the Global Economy Workshop

Decision Theory and Operations Research