**2. Some conceptual considerations about prospect theory and innovation**

### **2.1 The prospect theory**

Prospect theory is a branch of behavioral economics that describes how people make decisions in uncertain situations. In contrast to the expected utility model, which is based on the average of possible consequences of a choice, the prospect theory suggests that people do not follow this reasoning when making decisions.

For many years, the Expected Utility Theory guided scholars in decision-making, investors, and other economic agents. However, this theory failed to explain important aspects of portfolio valuation, culminating in the criticism of two researchers, the psychologist Daniel Kahneman (1934) and the economist Amos Tversky (1937–1996), with the launch of Prospect Theory.

At the beginning of the last century, the ordinal theory and revealed preferences emerged, thus discarding the hypothesis of the interaction between decision-making and subjective feelings. This fact contained the advance of the confusion generated by the psychology involved in the theory of utility.

Still, over the first decades of the last century, economics underwent a transformation by adopting mathematics as one of its main analytical tools. Therefore, they no longer needed complex—and unreliable—analyses related to the "thoughts and feelings" of decision-makers.

For example, Game Theory gained enormous prominence at that time, in particular, with the works of John Von Neumann (1903–1957) and Oskar Morgenstern *Innovation and Entrepreneurship: The Role of Prospect Theory in Decision-Making DOI: http://dx.doi.org/10.5772/intechopen.111396*

(1902–1997). The main idea of these authors was that, as in board games, economic behavior could be studied by creating games that simulated a specific economic decision-making situation.

Continuing, John Nash's (1928–2015) studies on the equilibrium point in noncooperative games, with multiple players, gave rise to interest in Game Theory in several areas of social sciences, including economics.

One of the main criticisms of the new mathematical level of economics was made by the economist Maurice Allais (1911–2010). He questioned the hypothesis of the full rationality of human beings in making economic decisions, which, in this new aspect of economics, was widely defended and used. Particularly, in situations of risk or uncertainty, human beings were completely different from what the economicmathematical theory presented.

However, it was only with the work of Daniel Kahneman and Amos Tversky that an adequate solution was found for the problem of "exaggerated rationality" in situations of risk and uncertainty—the Prospect Theory emerged. "According to [1] you know you have made a theoretical breakthrough when you can no longer reconstruct why you failed for so long to see the obvious."

"The Prospect Theory sought to break with the traditional idea that a single theory of human behavior can be both normative and descriptive [2]." "According to [3] the alternatives for a decision problem can be structured in different ways, even if the results are equivalent." Therefore, irrationality can be explained by the way the decision alternatives are presented. For example, if the utility of wealth is all that matters, then transparently equivalent statements of the same problem should produce identical choices [1]. But this is not what happens in practice.

In addition, the norms, habits, and personal characteristics of those who make the decision can also bias the choice of alternatives. Kahneman and Tversky suggest that due to imperfections in human perception, changes in perspective can reverse the apparent relative size of objects and the level of desire for each option. In a survey carried out with students at Stanford and Columbia Universities, Kahneman and Tversky found evidence that changing perspectives for a given problem can influence and bias the choice of alternatives. For them, it was evident that in choices, involving certain gains, individuals are risk-averse and in choices, involving certain losses, they are prone to risk [3].

As a result, most of the time, the impact of losses is greater than the impact of gains. Representing it numerically, it is equivalent to saying that the pain of losing U\$1000 is greater than the pleasure of winning U\$1000.

Still, there are three cognitive features in Prospect Theory. They are [1] as follows:


#### 3.Loss aversion.

No theory is infallible, and it is just the theory that best explains a phenomenon. Or, still, it is simply the Theory accepted by the majority of the people. Therefore, Prospect Theory also has its flaws. "For [1] Prospect Theory does not know how to deal with disappointment (for example, of not winning anything). Furthermore, she failed to admit regret."

But, criticisms of Prospect Theory go beyond the two points highlighted by Kahneman. According to the Portuguese neuroscientist, António Damásio (1944), the considerations on the Prospect Theory are innovative and skillfully developed. After all, they showed unprecedented particularities about human economic decision-making. However, Daniel Kahneman and Amos Tversk did not explain why human beings make irrational decisions. For Damásio, the explanation lies in the field of neuroscience, specifically, in the functioning of "somatic markers." Therefore, the functioning of the brain (and the body) makes it possible to safely investigate the triggering of the most relevant "somatic" responses.

When a bad result associated with a given response option appears, however fleeting it may be, we feel an unpleasant visceral sensation. As sensation is bodily, the phenomenon is technically called "somatic" state (in Greek, soma means body); and, because the state marks an image, we call it markers. Therefore, Damásio argues that when we analyze the infinity of future possibilities arising from each decision we can make in a given dilemma, the brain automatically marks these scenarios with a "marker," positive or negative, according to the feelings that these imaginary scenarios arouse in us [3].

Therefore, the somatic marker is what allows the restriction among infinite possible decisions to be taken, selecting only a small set of rationally analyzed choices.

Interestingly, the "somatic marker" mechanism seems consistent with the theory of bounded rationality. According to the assumption of bounded rationality. There are two decision-making problems:


Finally, to understand the decision-making process, especially in the context of risk and uncertainty, the decision-maker is not obliged to know the historical evolution of this process. However, such knowledge provides the basis for explaining many past events in the economy. And, it allows comparison with the Prospect Theory, that is, it clarifies between the decision that should be (traditional economics) and the decision that "real" people make in their day-to-day economic interactions.

#### **2.2 Innovation**

An innovation can generate unimaginable gains in all areas of the economy. If an innovation is successful, as in the case of Henry Ford's cars or Melitta Bentz's coffee filter, it can change the lives of entrepreneurs, companies, countries, and even the entire world. However, nothing is more risky than innovating—no one knows what the future holds. Therefore, innovation is a challenge that requires specific skills from innovators.

Innovating means giving life to an original product or service, and it is a broad concept applicable to several areas. However, "according to [4] value innovation occurs only when companies align innovation with utility, price, and cost gains."

A recent example of innovation occurred on February 7, 2023, when Microsoft CEO Satya Nadella told journalists that artificial intelligence was opening up new possibilities in the field of research. Microsoft, which had long been criticized for its search engine, Bing, decided to incorporate OpenAI's ChatGPT technology to provide direct information to users instead of just presenting links. With this, the company directly challenged the undisputed search engine leader, Google, by innovating in its own territory [5].

Capitalism works thanks to new products, production methods, and markets created by companies. This changes the economy, destroying the old structure and creating a new one. This is called "creative destruction" and is essential to understanding capitalism [6].

According to Schumpeter, the following situations can be considered innovation [6]:

1.Introduction of a new good;

2.Introduction of a new production method;

3.Opening a new market;

4.Conquest of a new source of supply of raw materials or semifinished goods;

5.Establishment of a new organization of any industry.

An example of product innovation can be identified in the launch of the iPhone by Apple in 2007. This innovation was characterized by the combination of various functions in a single portable device, including phone, internet, music, and camera, among others. Thus, the iPhone represented a break from conventional cell phones of the time, which were limited mainly to making phone calls and sending text messages. In addition, the elegant and intuitive design of the iPhone also represented an innovation compared to the existing cell phones at that time, which generally had physical keyboards and complex interfaces. In summary, the launch of the iPhone had a significant impact on the smartphone market, transforming the way people communicate and access information.

Innovation also provides indirect gains. Here are four of them [7]:


"According to [4] innovation can occur in three platforms: product, service, and delivery." According to this approach, the most successful companies regarding innovation are those that take advantage of the three platforms in which value innovations occur:


Innovation encompasses the entire process of developing ideas to capture returns and comprises three phases of action, each with a different result [7]:


It is equally important to differentiate between "invention" and "innovation." While invention involves the creation or discovery of a new product or process, innovation pertains to the successful introduction and adoption of a new product or process in the market.

In addition, the timing of the generation of an innovation is crucial. However, an innovation happens when an inventor seeks the realization of his dreams through the commercialization of his brilliant idea in the market. It also happens when there is a specific need or demand to be met and when there is a clear opportunity to bring significant benefits to society, the economy, or the environment. Furthermore, it is important that the innovation is viable and sustainable in financial, technical, and social terms.

Just as innovation generates direct and indirect gains, failure to innovate can generate direct losses, such as financial losses, indirect losses, such as the depreciation of the entrepreneur's reputation.

Innovating can involve several costs for a company, both financial and nonfinancial. Some of the more common costs include


*Innovation and Entrepreneurship: The Role of Prospect Theory in Decision-Making DOI: http://dx.doi.org/10.5772/intechopen.111396*


In addition to conceptual aspects, innovation is influenced by a management culture. This culture, which is conducive to innovation, is not just good for a company's bottom line. It is also something that both leaders and employees value in their organizations. But despite the fact that innovative cultures are desirable and most leaders claim to understand what they entail, they are difficult to create and sustain [8].

In this context, entrepreneurship emerges as a concept related to innovation. "Enterprise" is the realization of new combinations; we call "entrepreneurs" the individuals whose function it is to carry them out [9].

Entrepreneurial discovery, for Kirzner, unlike Schumpeter, comes out of nowhere and entrepreneurship consists of a state of alertness: being alert, ready to perceive profit opportunities that have not yet been explored and take advantage of them. For him, the market is not a state, but a process of a dynamic reality in constant movement and never in equilibrium, where the entrepreneur acts as an internal element and an integral part of the system, and not as a destroyer of a supposedly perfect equilibrium, but as a the agent who observes and takes advantage of opportunities not yet explored, thus coordinating the various individual plans and triggering a mechanism that tends to balance. In this perspective, the entrepreneur is the engine of the system, the one who, in a way, from the beginning, enables the exploration of opportunities, interaction, exchange, and coordination of individual plans [10].

Nevertheless, according to Schumpeter's theory, entrepreneurs are responsible for disruptive innovations that change existing markets. These innovations generate above-average profits for pioneering firms, attracting the entry of imitators and Kirznerian-type entrepreneurs. These entrepreneurs seek to reduce excessive profits through competition, bringing the new market to a state of equilibrium in which firms compete on more equal terms. In this way, entrepreneurs play a key role in economic development, driving innovation and competition, and contributing to the long-term growth of the economy.

Finally, it is important to remember that innovation is not an end in itself, but a means to meet specific needs and demands. Therefore, innovation must be carried out in a responsible and ethical manner, taking into account the values and objectives of the organization or society in general.
