Expected utility theory was developed by Swiss mathematician Daniel Bernoulli. Expected utility theory is a tool aimed to help make decisions amongst various possible choices. It is a way to balance risk versus reward using a formal, mathematical function.
For example you have 3 job offers.
1. First job offers Rs.5 lakhs and probability of getting it is 100%.
2. Second job offer is of Rs.9 lakhs, and probability of getting it is 60%
3. Third job offer is of Rs. 6 lakhs and probability of getting it is 80%
Which one will you choose?
Firstly, calculate expected utility of each, it is 5, 5.4 and 4.8 resp., so a rational person will go for offer 2.
This theory was criticised by two psychologists Daniel Kahneman and Amos Nathan Tversky. They came up with own theory called Prospect theory, as per their theory most will go for option 1 as certainty of getting job is more in option 1 compared to options 2 & 3.
Prospect theory states that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.
This theory has applications in field of risk, game theory, behavioural economics etc.
Kahneman (despite being a psychologist) was awarded the 2002 Nobel Prize in Economics for his work in prospect theory.
The theory also states that joy of getting certain amount say Rs.100 is much less than sorrow of losing Rs.100.
This has implications for HR manager. Sometime during April/May every year, HR guys calculate performance linked pay and increments. Performance linked pay/performance bonus/variable pay is linked to various financial (revenue, PAT, FCF etc.) and non-financial factors (CSS, ESS) in additional to individual’s performance. While increments, in addition to individual’s performance also depend on inflation rate, capacity of organisation to pay, what competitors are paying etc.
Suppose a manager gets salary of Rs. 100, of which variable is 30%, performance index based on various factors comes to .5, so manager ends up getting Rs.15 as variable pay, so loss of Rs. 15 ( assuming bonus is capped at 100%), at the same time company gives him increment of 15%, so he gains Rs.15. But sorrow of losing Rs. 15 will be far more than joy of getting Rs. 15. Better option would have been paying 100% performance bonus but lesser increments!
Next time HR manager should think of prospect theory while announcing performance bonus and increments.