Proposed framework for applying cumulative prospect theory to an unbalanced bidding model

Recent research on unbalanced bidding models has identified both the benefits and the risks generated from different prices applied to the component items of a construction project. It has also been proposed that modern portfolio theory (MPT) be used as the technique by which to trade-off the conflicting objectives of maximizing the expected profit and, at the same time, minimizing the risk. The MPT methodology has previously been found to provide contractors with a technique by which they can identify and sift out all of the efficient item-price combinations, such that they need not suffer the consequences of deciding upon any substandard inefficient pricing combination. The use of MPT still leaves contractors with a wide range of choices. This paper introduces and applies microeconomic techniques [namely cumulative prospect theory (CPT)] to narrow these choices down to only one optimal choice. CPT serves to equate different return-risk alternatives to find the one set of item prices that will provide the optimal outcome in light of the contractor's risk profile. The paper concludes by applying and evaluating this technique, on a small hypothetical project. Results show that a contractor with such a profile is able to identify prices that will generate an expected mean profit of 150%, more than they could accomplish by way of balanced pricing.