Reference Dependence in Multilocation Newsvendor Models: A Structural Analysis

• Published in: Management science Vol. 56; no. 11; pp. 1891 - 1910
• Main Authors: Ho, Teck-Hua, Lim, Noah, Cui, Tony Haitao
• Format: Journal Article
• Language: English
• Published: Hanover, MD INFORMS 01.11.2010; Institute for Operations Research and the Management Sciences
• Series: Management Science
• Subjects: Applied sciences; Behavior; Behavior modeling; behavioral operations management; Behavioural psychology; Bias; Business orders; Cash; Cost estimation models; Costs; Economics; Estimating techniques; Exact sciences and technology; experimental economics; Experiments; General aspects; Human behaviour; Inventories; Inventory control, production control. Distribution; Inventory management; Management science; Mathematical programming; Modeling; Motivation; multilocation inventory system; newsvendor; Operational research and scientific management; Operational research. Management science; Operations management; Parametric models; Preferences; Profit; Profit margins; Psychology; Queuing theory. Traffic theory; Rationality; Regression analysis; Risk; Structural analysis; Studies; Unit costs; Costs; Bias; Psychology; Newsboy problem; Modeling; Mutualism; Location problem; Economy; Behavioral analysis; Dependence; Ordering; Inventory control; Profit; Call centres; Localization; newsvendor; Empirical method; Minimization; Financial incentives; Production management; Preference; behavioral operations management; Structural model; experimental economics; Stockout; Risk management; multilocation inventory system
• ISSN: 0025-1909; 1526-5501
• DOI: 10.1287/mnsc.1100.1225

We 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.