Newsvendor revisited: risk premiums of loss aversion

Abstract

The classical newsvendor model in economics and decision theory treats losses and gains equally likely. However, decision makers are usually loss-averse as probable losses have more impact on humans than probable gains. This study presents a new variant of the newsvendor problem of loss-averse decision makers. The optimal order quantity is found by maximizing the expected utility of bounded functions. The implications of loss aversion on the certainty equivalents and risk premiums were also analyzed. Two case studies of exponential utility and normal demand were considered. A new elegant form of the optimal order quantity is established. The results show that when exponential loss aversion exists, the newsvendor optimal quantity serves as a lower(upper) bound on the optimal quantities. Moreover, high loss aversion entails higher RP. Similar findings hold by increasing the overage/underage costs and the demand standard deviation. Possible future extensions are demonstrated at the end of the paper.

Ranking risk attitudes using an integrated AHP-TOPSIS approach

“…The individualism, power distance, and masculinity increase loss aversion while a less significant impact of uncertainty avoidance was noticed (Wang et al, 2017). When an exponential loss aversion exists, the decision-makers optimal quantity serves as a lower bound when the overage costs are high, and an upper bound when the underage costs are high (Alkhaledi et al, 2018;Dalalah, 2019). Also, loss aversion entails a higher risk premium.…”

Risk premiums and certainty equivalents of loss-averse newsvendors of bounded utility

“…Other researchers have used the possibility theory instead of the conventional probability theory as in Guo and Chen (2000). Alkhaledi et al (2018) used a scaled utility function to highlight the impact of losses as compared to gains in the newsvendor problem.…”