Reference Dependence in Multilocation Newsvendor Models: A Structural Analysis

Abstract

W e propose a behavioral theory to predict actual ordering behavior in multilocation inventory systems. The theory rests on a well-known stylized fact of human behavior: people's preferences are reference dependent. We incorporate reference dependence into the newsvendor framework by assuming that there are psychological costs of leftovers and stockouts. We also hypothesize that the psychological aversion to leftovers is greater than the disutility for stockouts. We then experimentally test the proposed theory in both the centralized and decentralized inventory structures using subjects motivated by substantial financial incentives. Consistent with the proposed theory, actual orders exhibit the so-called "pull-to-center" bias and the degree of bias is greater in the high-profit margin than in the low-profit margin condition. These systematic biases are shown to eliminate the risk-pooling benefit when the demands across store locations are strongly correlated. Because the proposed model nests the standard inventory and ex post inventory error minimization theories as special cases, one can systematically evaluate the predictive power of each alternative using the generalized likelihood principle. We structurally estimate all three theories using the experimental data, and the estimation results strongly suggest that the proposed behavioral theory captures actual orders and profits better. We also conduct two experiments to validate the behavioral model by manipulating the relative salience of the psychological costs of leftovers versus that of stockouts to alleviate the pull-to-center bias.

Information Reliability in Supply Chains: The Case of Multiple Retailers

“…By doing so, we avoid experimental results to be influenced by the "pull-to-center" effect when setting the inventory quantity; the phenomenon of systematically ordering too little when the cost of underage is high and ordering too much when the cost of overage is high. This phenomenon may be explained by some well-known decision biases, e.g., anchoring and insufficient adjustment, observation bias, reference-dependent preferences and is well documented in the literature in single newsvendor [5,7,47] and multilocation newsvendor models [28]. The number of participants in each treatment was decided based on the supply chain group synthesis in each case (one vs. two retailers), taking into account the probability that a specific group will play more than once and the average number of rounds a given group is expected to play.…”

“…They find that the value of pooling may be negative when the inventory policy in use is suboptimal while it varies little across the distributions they studied. More recently, [28] study experimentally the ordering behavior in multilocation inventory systems and they show that systematic biases eliminate the risk-pooling benefit when the demand across stores is strongly correlated. They propose a behavioral theory based on reference dependence (psychological aversion to leftovers is greater than the disutility of stockouts) to explain / predict ordering behavior in a multi-location newsvendor framework, under both a centralized and a decentralized inventory structure.…”

The Effect of Payment Schemes on Inventory Decisions: The Role of Mental Accounting

“…For example, Schweitzer and Cachon (2000) first found the pullto-center effect in the newsvendor problem. Various influencing factors in newsvendor decisions are also investigated, such as decision heuristics (Bostian et al 2008), the role of learning and feedback Katok 2008, Lurie andSwaminathan 2009), demand estimation biases (Feiler et al 2012), psychological costs (Ho et al 2010), and bounded rationality (Su 2008, Kremer et al 2010. In a serial supply chain setting, Sterman (1989) and Donohue (2005, 2006) found that human subjects do not sufficiently account for the pipeline inventory and subsequently overreact to their inventory levels, contributing to the bullwhip effect.…”

Loss Aversion and Residential Property Development Decisions in China: A Semi-Parametric Estimation

“…Other promising applications include the optimal contract form and compensation schemes for loss-averse chief executive officers (de Meza and Webb 2007, Dittmann et al 2010, and Herweg et al 2010; consumption insensitivity to bad news of future income (Bowman, Minehart, and Rabin 1999); optimal ordering when managers or news vendors are loss averse (Ho et al 2010, Wang and Webster 2007, and Wang 2010; and so on.…”