Implications of prospect theory for the asymmetric behavior of costs

Abstract

A growing body of research documents an asymmetric behavior of costs, implying that costs rise more in response to sales increases than they drop for sales decreases. Also known as cost stickiness, this cost behavior is ascribed to managerial decisions on resource commitment. In this study, we build on core components of prospect theory to further explore this asymmetry and examine how such cost asymmetry may be affected by risk preferences in managerial decision making when firms face declining (increasing) activity. In particular, we hypothesize how risk taking (aversion) in the domain of losses (gains) as well as industry performance as a reference point for firm performance act as determinants of managerial decision making on resource commitment decisions. To test these hypotheses, we use secondary unbalanced panel data on 3,558 companies across nine industry sectors from 26 countries around the world over the period of six years (2008-2013). We contribute to existing literature on asymmetric cost behavior in considering the role of risk preferences in different domains (losses and gains) as well as the role of industry performance as a reference point for managerial decision making on resource commitment.