IDEAS home Printed from https://ideas.repec.org/a/inm/ormsom/v21y2019i3p481-500.html
   My bibliography  Save this article

Modeling Newsvendor Behavior: A Prospect Theory Approach

Author

Listed:
  • Bhavani Shanker Uppari

    (INSEAD, Singapore 138676)

  • Sameer Hasija

    (INSEAD, Singapore 138676)

Abstract

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 operations management literature. Although prospect theory has been established as a popular model of behavioral decision making under uncertainty, it was considered to be inconsistent with observed newsvendor behavior (in particular, the pull-to-center effect) until a recent study by Long and Nasiry [Long X, Nasiry J (2015) Prospect theory explains newsvendor behavior: The role of reference points. Management Sci. 61(12):3009–3012.] proposed a prospect theory model that is consistent with the pull-to-center effect; however, this model’s ability in representing newsvendor behavior compared to other plausible prospect theory models is unexplored in the literature. This paper takes a more comprehensive approach in building several prospect theory-based newsvendor models and evaluates their competence in representing the observed newsvendor behavior. An important feature of these models is that they are not only consistent with the pull-to-center effect, but they can also, in accordance with the findings from recent research, accommodate individual-level heterogeneity in order quantities. 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. Our paper provides a rigorous basis for choosing a model when characterizing the decision making process of a newsvendor. Moreover, our novel approach to model building and testing could serve as a template for selecting appropriate prospect theory models in contexts other than the newsvendor problem. Methodology : Motivated by different types of reference points studied in the decision theory literature, we first build several newsvendor models that can theoretically accommodate individual-level heterogeneity in order quantities. Thereafter, using a multipronged approach based on theoretical criteria, goodness of fit, and empirical validity, 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 the prediction error by as much as 31% on the experimental data used for this study. Moreover, all the empirical regularities considered in our paper are consistent only with this model. This suggests that mean demand is more likely to be adopted by experimental subjects as a reference point—perhaps because of its greater salience than the other plausible reference points considered. Managerial implications : Since decisions are made predominantly by human retailers in the emerging markets, we represent their behavior by the model with mean demand as the reference point and identify settings in which they could benefit from investing in decision support systems. We also demonstrate the benefits to a supplier from approximating his retailers’ behavior with this model relative to him using the other prospect theory models considered in this paper.

Suggested Citation

  • Bhavani Shanker Uppari & Sameer Hasija, 2019. "Modeling Newsvendor Behavior: A Prospect Theory Approach," Manufacturing & Service Operations Management, INFORMS, vol. 21(3), pages 481-500, July.
  • Handle: RePEc:inm:ormsom:v:21:y:2019:i:3:p:481-500
    DOI: 10.1287/msom.2017.0701
    as

    Download full text from publisher

    File URL: https://doi.org/10.1287/msom.2017.0701
    Download Restriction: no

    File URL: https://libkey.io/10.1287/msom.2017.0701?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Johannes Abeler & Armin Falk & Lorenz Goette & David Huffman, 2011. "Reference Points and Effort Provision," American Economic Review, American Economic Association, vol. 101(2), pages 470-492, April.
    2. Herweg, Fabian, 2013. "The expectation-based loss-averse newsvendor," Economics Letters, Elsevier, vol. 120(3), pages 429-432.
    3. AJ A. Bostian & Charles A. Holt & Angela M. Smith, 2008. "Newsvendor "Pull-to-Center" Effect: Adaptive Learning in a Laboratory Experiment," Manufacturing & Service Operations Management, INFORMS, vol. 10(4), pages 590-608, July.
    4. Raj Chetty & Adam Looney & Kory Kroft, 2009. "Salience and Taxation: Theory and Evidence," American Economic Review, American Economic Association, vol. 99(4), pages 1145-1177, September.
    5. Katok, Elena, 2011. "Using Laboratory Experiments to Build Better Operations Management Models," Foundations and Trends(R) in Technology, Information and Operations Management, now publishers, vol. 5(1), pages 1-86, November.
    6. Botond Kőszegi & Matthew Rabin, 2006. "A Model of Reference-Dependent Preferences," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 121(4), pages 1133-1165.
    7. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    8. Opher Baron & Ming Hu & Sami Najafi-Asadolahi & Qu Qian, 2015. "Newsvendor Selling to Loss-Averse Consumers with Stochastic Reference Points," Manufacturing & Service Operations Management, INFORMS, vol. 17(4), pages 456-469, October.
    9. Mohammed Abdellaoui & Han Bleichrodt & Corina Paraschiv, 2007. "Loss Aversion Under Prospect Theory: A Parameter-Free Measurement," Management Science, INFORMS, vol. 53(10), pages 1659-1674, October.
    10. Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2012. "Salience Theory of Choice Under Risk," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(3), pages 1243-1285.
    11. Wedad Elmaghraby & Wolfgang Jank & Shu Zhang & Itir Z. Karaesmen, 2015. "Sales Force Behavior, Pricing Information, and Pricing Decisions," Manufacturing & Service Operations Management, INFORMS, vol. 17(4), pages 495-510, October.
    12. Nelson Lau & J. Neil Bearden, 2013. "Newsvendor Demand Chasing Revisited," Management Science, INFORMS, vol. 59(5), pages 1245-1249, May.
    13. Neilson, William S, 2002. "Comparative Risk Sensitivity with Reference-Dependent Preferences," Journal of Risk and Uncertainty, Springer, vol. 24(2), pages 131-142, March.
    14. Mahesh Nagarajan & Steven Shechter, 2014. "Prospect Theory and the Newsvendor Problem," Management Science, INFORMS, vol. 60(4), pages 1057-1062, April.
    15. Bowman, David & Minehart, Deborah & Rabin, Matthew, 1999. "Loss aversion in a consumption-savings model," Journal of Economic Behavior & Organization, Elsevier, vol. 38(2), pages 155-178, February.
    16. Enrico G. De Giorgi & Thierry Post, 2011. "Loss Aversion with a State-Dependent Reference Point," Management Science, INFORMS, vol. 57(6), pages 1094-1110, June.
    17. Gary E. Bolton & Elena Katok, 2008. "Learning by Doing in the Newsvendor Problem: A Laboratory Investigation of the Role of Experience and Feedback," Manufacturing & Service Operations Management, INFORMS, vol. 10(3), pages 519-538, September.
    18. Wenner, Lukas M., 2015. "Expected prices as reference points—Theory and experiments," European Economic Review, Elsevier, vol. 75(C), pages 60-79.
    19. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    20. John C. Hershey & Paul J. H. Schoemaker, 1985. "Probability Versus Certainty Equivalence Methods in Utility Measurement: Are they Equivalent?," Management Science, INFORMS, vol. 31(10), pages 1213-1231, October.
    21. Anssi Käki & Juuso Liesiö & Ahti Salo & Srinivas Talluri, 2015. "Newsvendor decisions under supply uncertainty," International Journal of Production Research, Taylor & Francis Journals, vol. 53(5), pages 1544-1560, March.
    22. Yufei Ren & Rachel Croson, 2013. "Overconfidence in Newsvendor Orders: An Experimental Study," Management Science, INFORMS, vol. 59(11), pages 2502-2517, November.
    23. Maurice E. Schweitzer & Gérard P. Cachon, 2000. "Decision Bias in the Newsvendor Problem with a Known Demand Distribution: Experimental Evidence," Management Science, INFORMS, vol. 46(3), pages 404-420, March.
    24. Enrico Diecidue & Jeroen van de Ven, 2008. "Aspiration Level, Probability Of Success And Failure, And Expected Utility," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(2), pages 683-700, May.
    25. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-686, May.
    26. Charles Sprenger, 2015. "An Endowment Effect for Risk: Experimental Tests of Stochastic Reference Points," Journal of Political Economy, University of Chicago Press, vol. 123(6), pages 1456-1499.
    27. Xuanming Su, 2008. "Bounded Rationality in Newsvendor Models," Manufacturing & Service Operations Management, INFORMS, vol. 10(4), pages 566-589, May.
    28. Xiaoyang Long & Javad Nasiry, 2015. "Prospect Theory Explains Newsvendor Behavior: The Role of Reference Points," Management Science, INFORMS, vol. 61(12), pages 3009-3012, December.
    29. Kobberling, Veronika & Wakker, Peter P., 2005. "An index of loss aversion," Journal of Economic Theory, Elsevier, vol. 122(1), pages 119-131, May.
    30. Bruce G. S. Hardie & Eric J. Johnson & Peter S. Fader, 1993. "Modeling Loss Aversion and Reference Dependence Effects on Brand Choice," Marketing Science, INFORMS, vol. 12(4), pages 378-394.
    31. Sylvie M. C. van Osch & Wilbert B. van den Hout & Anne M. Stiggelbout, 2006. "Exploring the Reference Point in Prospect Theory: Gambles for Length of Life," Medical Decision Making, , vol. 26(4), pages 338-346, July.
    32. Sugden, Robert, 2003. "Reference-dependent subjective expected utility," Journal of Economic Theory, Elsevier, vol. 111(2), pages 172-191, August.
    33. Michael Becker-Peth & Elena Katok & Ulrich W. Thonemann, 2013. "Designing Buyback Contracts for Irrational But Predictable Newsvendors," Management Science, INFORMS, vol. 59(8), pages 1800-1816, August.
    34. David E. Bell, 1985. "Disappointment in Decision Making Under Uncertainty," Operations Research, INFORMS, vol. 33(1), pages 1-27, February.
    35. Ockenfels, Axel & Selten, Reinhard, 2014. "Impulse balance in the newsvendor game," Games and Economic Behavior, Elsevier, vol. 86(C), pages 237-247.
    36. Samuel Nathan Kirshner & Anton Ovchinnikov, 2019. "Heterogeneity of Reference Effects in the Competitive Newsvendor Problem," Manufacturing & Service Operations Management, INFORMS, vol. 21(3), pages 571-581, July.
    37. Sameer Hasija & Edieal Pinker & Robert A. Shumsky, 2010. "OM Practice--Work Expands to Fill the Time Available: Capacity Estimation and Staffing Under Parkinson's Law," Manufacturing & Service Operations Management, INFORMS, vol. 12(1), pages 1-18, September.
    38. Nicholas C. Barberis, 2013. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," Journal of Economic Perspectives, American Economic Association, vol. 27(1), pages 173-196, Winter.
    39. Wakker, Peter & Tversky, Amos, 1993. "An Axiomatization of Cumulative Prospect Theory," Journal of Risk and Uncertainty, Springer, vol. 7(2), pages 147-175, October.
    40. Kahneman, Daniel, 1992. "Reference points, anchors, norms, and mixed feelings," Organizational Behavior and Human Decision Processes, Elsevier, vol. 51(2), pages 296-312, March.
    41. Graham Loomes & Robert Sugden, 1986. "Disappointment and Dynamic Consistency in Choice under Uncertainty," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 53(2), pages 271-282.
    42. Nils Rudi & David Drake, 2014. "Observation Bias: The Impact of Demand Censoring on Newsvendor Level and Adjustment Behavior," Management Science, INFORMS, vol. 60(5), pages 1334-1345, May.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kannan, Devika, 2021. "Sustainable procurement drivers for extended multi-tier context: A multi-theoretical perspective in the Danish supply chain," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 146(C).
    2. Sharifi, Rozhin & Razavi, Hamideh & Elahi, Ehsan, 2023. "Investigation of the ordering behavior of a retailer in the revenue sharing and buyback contracts considering round number bias," Journal of Retailing and Consumer Services, Elsevier, vol. 73(C).
    3. Qingwei Wang & Meimei Zheng & Wei Weng, 2023. "Sourcing decisions with loss aversion under yield and demand randomness," OR Spectrum: Quantitative Approaches in Management, Springer;Gesellschaft für Operations Research e.V., vol. 45(2), pages 661-710, June.
    4. Jinrui Pan & Jason Shachat & Sijia Wei, 2022. "Cognitive Stress and Learning Economic Order Quantity Inventory Management: An Experimental Investigation," Decision Analysis, INFORMS, vol. 19(3), pages 229-254, September.
    5. Tian Bai & Samuel N. Kirshner & Meng Wu, 2021. "Managing Overconfident Newsvendors: A Target‐Setting Approach," Production and Operations Management, Production and Operations Management Society, vol. 30(11), pages 3967-3986, November.
    6. Bai, Tian & Wu, Meng & Zhu, Stuart X., 2019. "Pricing and ordering by a loss averse newsvendor with reference dependence," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 131(C), pages 343-365.
    7. Bao, Xing & Mirchandani, Prakash & Shang, Jennifer & Narayan, Ramasubbu, 2023. "Playing politics or playing right: Impacts of reputation-seeking on short-term disruptions management," Omega, Elsevier, vol. 116(C).
    8. Wenhui Zhou & Dongmei Wang & Weixiang Huang & Pengfei Guo, 2021. "To Pool or Not to Pool? The Effect of Loss Aversion on Queue Configurations," Production and Operations Management, Production and Operations Management Society, vol. 30(11), pages 4258-4272, November.
    9. Samuel N. Kirshner & Zhaolin Li, 2022. "Supply chain contracting with competing regretful retailers," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 43(6), pages 2196-2211, September.
    10. Jammernegg, Werner & Kischka, Peter & Silbermayr, Lena, 2022. "Heterogeneity, asymmetry and applicability of behavioral newsvendor models," European Journal of Operational Research, Elsevier, vol. 301(2), pages 638-646.
    11. Qingren He & Taiwei Shi & Botao Liu & Wanhua Qiu, 2022. "The Ordering Optimization Model for Bounded Rational Retailer with Inventory Transshipment," Mathematics, MDPI, vol. 10(7), pages 1-16, March.
    12. Diego D’Urso & Ferdinando Chiacchio & Evangelia Demerouti, 2021. "Measuring How Decision Support Systems Improve Newsvendors’ Performance: The Subjects’ Version," Sustainability, MDPI, vol. 13(18), pages 1-16, September.
    13. Samuel N. Kirshner & Brent B. Moritz, 2023. "For the future and from afar: Psychological distance and inventory decision‐making," Production and Operations Management, Production and Operations Management Society, vol. 32(1), pages 170-188, January.
    14. Chen, Mingyang & Zhao, Daozhi & Gong, Yeming & Hong, Zhaofu, 2021. "Reference-dependent preferences in the on-demand service newsvendor with self-scheduling capacity," International Journal of Production Economics, Elsevier, vol. 234(C).
    15. Wei Liu & Shiji Song & Ying Qiao & Han Zhao & Huachang Wang, 2020. "The Loss-Averse Newsvendor Problem with Random Yield and Reference Dependence," Mathematics, MDPI, vol. 8(8), pages 1-15, July.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Aurélien Baillon & Han Bleichrodt & Vitalie Spinu, 2020. "Searching for the Reference Point," Management Science, INFORMS, vol. 66(1), pages 93-112, January.
    2. González-Jiménez, Víctor, 2024. "Incentive design for reference-dependent preferences," Journal of Economic Behavior & Organization, Elsevier, vol. 221(C), pages 493-518.
    3. Dertwinkel-Kalt, Markus & Köster, Mats, 2017. "Salient compromises in the newsvendor game," Journal of Economic Behavior & Organization, Elsevier, vol. 141(C), pages 301-315.
    4. Becker-Peth, Michael & Thonemann, Ulrich W., 2016. "Reference points in revenue sharing contracts—How to design optimal supply chain contracts," European Journal of Operational Research, Elsevier, vol. 249(3), pages 1033-1049.
    5. Wei, Ying & Xiong, Sijia & Li, Feng, 2019. "Ordering bias with two reference profits: Exogenous benchmark and minimum requirement," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 128(C), pages 229-250.
    6. Ulrich Schmidt & Horst Zank, 2012. "A genuine foundation for prospect theory," Journal of Risk and Uncertainty, Springer, vol. 45(2), pages 97-113, October.
    7. Katarzyna M. Werner & Horst Zank, 2019. "A revealed reference point for prospect theory," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 67(4), pages 731-773, June.
    8. Vipin, B. & Amit, R.K., 2019. "Describing decision bias in the newsvendor problem: A prospect theory model," Omega, Elsevier, vol. 82(C), pages 132-141.
    9. Yinghao Zhang & Karen Donohue & Tony Haitao Cui, 2016. "Contract Preferences and Performance for the Loss-Averse Supplier: Buyback vs. Revenue Sharing," Management Science, INFORMS, vol. 62(6), pages 1734-1754, June.
    10. Cao, Bing-Bing & Fan, Zhi-Ping & You, Tian-Hui, 2017. "The newsvendor problem with reference dependence, disappointment aversion and elation seeking," Chaos, Solitons & Fractals, Elsevier, vol. 104(C), pages 568-574.
    11. Zhihua Li & Songfa Zhong, 2023. "Reference Dependence in Intertemporal Preference," Management Science, INFORMS, vol. 69(1), pages 475-490, January.
    12. Karen Donohue & Özalp Özer, 2020. "Behavioral Operations: Past, Present, and Future," Manufacturing & Service Operations Management, INFORMS, vol. 22(1), pages 191-202, January.
    13. Park, Hyeon, 2023. "A general equilibrium model of dynamic loss aversion," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 107(C).
    14. Tian Bai & Samuel N. Kirshner & Meng Wu, 2021. "Managing Overconfident Newsvendors: A Target‐Setting Approach," Production and Operations Management, Production and Operations Management Society, vol. 30(11), pages 3967-3986, November.
    15. Wenhui Zhou & Dongmei Wang & Weixiang Huang & Pengfei Guo, 2021. "To Pool or Not to Pool? The Effect of Loss Aversion on Queue Configurations," Production and Operations Management, Production and Operations Management Society, vol. 30(11), pages 4258-4272, November.
    16. Alex Markle & George Wu & Rebecca White & Aaron Sackett, 2018. "Goals as reference points in marathon running: A novel test of reference dependence," Journal of Risk and Uncertainty, Springer, vol. 56(1), pages 19-50, February.
    17. Horst Zank, 2010. "On probabilities and loss aversion," Theory and Decision, Springer, vol. 68(3), pages 243-261, March.
    18. Enrico G. De Giorgi & Thierry Post, 2011. "Loss Aversion with a State-Dependent Reference Point," Management Science, INFORMS, vol. 57(6), pages 1094-1110, June.
    19. Jakusch, Sven Thorsten & Meyer, Steffen & Hackethal, Andreas, 2019. "Taming models of prospect theory in the wild? Estimation of Vlcek and Hens (2011)," SAFE Working Paper Series 146, Leibniz Institute for Financial Research SAFE, revised 2019.
    20. repec:cup:judgdm:v:16:y:2021:i:6:p:1324-1369 is not listed on IDEAS
    21. Ockenfels, Axel & Selten, Reinhard, 2014. "Impulse balance in the newsvendor game," Games and Economic Behavior, Elsevier, vol. 86(C), pages 237-247.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:inm:ormsom:v:21:y:2019:i:3:p:481-500. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Asher (email available below). General contact details of provider: https://edirc.repec.org/data/inforea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.