The newsvendor problem: The role of prospect theory and feedback

Experimental studies on newsvendor ordering behavior offer conflicting explanations as to the cause of the deviation from the optimal risk-neutral behavior. With one exception, studies have neither explored prospect theory as possible explanations, nor investigated exactly how this prospecting behavior comes to be. We conduct two experiments and demonstrate that a newsvendor, indeed, exhibits prospecting behavior and that this behavior is triggered by the relative value of the overage and the underage costs. These relative values help create a frame of reference that puts the newsvendor in either a gain-frame or a loss-frame. When the overage cost is less than the underage cost, a newsvendor is in a loss-frame and acts in a risk-seeking manner by ordering more than the optimal, and when the overage cost is more than the underage cost, the newsvendor is in a gain-frame and acts in a risk-averse manner by ordering less than the optimal, as prospect theory suggests. We also show the newsvendor does not use mean demand anchoring with insufficient adjustment heuristic to determine either the initial or the subsequent order quantity. The newsvendor is willing to change the decision in response to changes in parameters, consistent with prospect theory. Two forms of feedback are also supplied; however, feedback does not result in improved decision-making with a commensurate reduction in either systematic bias or prospecting behavior. Surprisingly, the newsvendor becomes more risk-seeking over time rather than risk-neutral. We conclude with a discussion of our findings, managerial insights, and possible future directions.