What is the prospect theory of entrepreneurship?
Prospect theory was developed by behavioral economists Daniel Kahneman and Amos Tversky in the 1970s. Their aim was to better understand decision making processes by looking at how individuals assess the potential gains and losses from a decision separately. The most famous hypothesis tied to the theory is that most individuals fear losses more than they value gains.
The theory posits that when individuals think they are winning (gain domain frame), they become more risk-averse, whereas when they think they are losing (loss domain frame), they become inclined to take bigger risks to get back to a break-even position.
According to Hsu et al. (2017): “So essentially, whether a person frames a situation as associated with gains or losses influences his or her attitude toward engaging in risky behaviors such as reentering entrepreneurship.” Entrepreneurs judge whether they are in a gain or loss position based on a reference point. For instance, Hsu et al. use the entrepreneurs’ wins and losses from prior entrepreneurial ventures as the reference point in their study.
A key insight from the theory is that entrepreneurs that have failed previously might interpret themselves as being in a loss position, which might encourage them to take even bigger risks in order to gain back what they lost. Looking at the chart below, the entrepreneur in the loss-frame would view him or herself as riding up a much steeper curve (i.e., the convex curve on the bottom left). This also suggests that an entrepreneur with already high income or previous success my subsequently take fewer risks because they would view themselves as riding up the concave curve on the top right.
Busenitz et al. suggests that entrepreneurs might use other reference points than industry standards, for instance, psychic (or psychological) benefit from entrepreneurship (e.g., autonomy). Prospect theory may thus help to explain why entrepreneurs take bold actions in the face of uncertainty.
Prospect theory seems highly related to the Regulatory focus theory of entrepreneurship.
Busenitz, L. W., West III, G. P., Shepherd, D., Nelson, T., Chandler, G. N., and Zacharakis, A. (2003). Entrepreneurship research in emergence: Past trends and future directions. Journal of management, 29(3), 285-308.
Hsu, D. K., Wiklund, J., and Cotton, R. D. (2017). Success, failure, and entrepreneurial reentry: An experimental assessment of the veracity of self‐efficacy and prospect theory. Entrepreneurship Theory and Practice, 41(1), 19-47.