Is Inventory Centralization Profitable? An Experimental Investigation

Abstract:     
A major tenet of standard multi-echelon inventory theory is that centralizing the inventory of a retailer with multiple stores yields greater profits because of the benefits of risk-pooling. However, this important theoretical prediction has not been empirically verified. This paper conducts incentive-compatible laboratory experiments to test whether order decisions and profits across centralized and decentralized inventory structures are in line with the predictions of the standard theory. The results show that while orders deviate systematically from the normative predictions, the predicted superiority of centralization survives bounded rationality. We develop a behavioral model that incorporates reference-dependence preferences and the well-documented human tendency to apply the law of small numbers and show that the model captures actual ordering decisions well. Since the proposed model nests the standard model as a special case, we can use it to formally quantify the extent to which actual behavior deviates from the standard model.

Keywords: newsvendor, behavioral economics, behavioral operations management, experimental economics

JEL Classifications: D03, D24, L11, M11

Working Paper Series