Modeling Newsvendor Behavior: A Prospect Theory Approach
Problem Definition: Studies have shown that the behavior of subjects in newsvendor experiments is not consistent with expected profit maximization an assumption that is often made in inventory and supply chain management literature. Although a pull to center effect in order quantities is observed in these experiments at the aggregate level, recent research has shown that this effect is not representative of the individual level behavior. There is remarkable heterogeneity in the order quantities, and the behavior of a significant proportion of subjects is inconsistent with the pull to center effect. We argue that the models in the extant literature cannot predict this heterogeneity and are inconsistent with certain observed empirical regularities. This paper studies several models that can predict such heterogeneity, and then evaluates their competence in representing the observed newsvendor behavior.Academic/Practical Relevance: Designing effective supply chain processes and inventory systems requires that the underlying models represent the observed newsvendor behavior reasonably well, especially in settings where most decisions are made by individuals. However, using the extant models for analysis ignores the behavior of a significant proportion of the population, which, therefore, necessitates building models that better represent newsvendor behavior.Methodology: First, we build several models based on the literature on prospect theory using different reference point assumptions that can theoretically accommodate heterogeneity in newsvendor order quantities. Thereafter, using a multipronged approach based on theoretical criteria, empirical validity, and goodness of fit, we evaluate these models to determine the most appropriate model.Results: The model with mean demand as the stochastic reference point consistently outperforms other models, reducing prediction error by as much as ~20% This model also reconciles heterogeneity at the individual level with two consistent observations at the aggregate level: the modal order quantity of the aggregate data tends to be mean demand and the mean order quantity of the aggregate data tends to lie in the pull to center zone. Moreover, all the empirical regularities considered in our paper are consistent only with this model.Managerial Implications: Since decisions are predominantly made by human retailers in the emerging markets (as opposed to decision support systems) we represent their behavior by the model with mean demand as reference point, and identify settings in which retailers could benefit from investing in decision support systems. In addition, we discuss the important role played by loss aversion and reference dependence in modeling the newsvendor behavior, and offer a template for identifying and selecting appropriate reference dependent models.
Manuf. Serv. Oper. Manag.