Probability Weighting and the Newsvendor Problem: Theory and Evidence

27 Pages Posted: 11 Oct 2021

See all articles by Xiao Huang

Xiao Huang

John Molson School of Business, Concordia University

Mahesh Nagarajan

University of British Columbia (UBC) - Sauder School of Business

Shanshan Guo

Shanghai University of Finance and Economics

Date Written: October 6, 2021

Abstract

Behavioral studies have consistently reported the pull-to-center (PTC) effect observed in laboratory studies of the newsvendor problem. We examine whether this and some other observed effects can be reconciled under the general framework of prospect theory without special assumption on reference point. Specifically, we allow decision makers to value each potential outcome with decision weight rather than the actual probability and further validate through some experiments if the PTC effect is correlated with the shape of the weighting function. The results confirm that the general framework of prospect theory can explain the PTC effect without special assumption on reference point. The only stipulation is a general set of probability weighting functions that that admit underweighting of small probabilities. The proposed model is inclusive, robust, and can explain a number of prominent newsvendor behavioural observations with reasonable benchmark predictions. Our finding suggests that the systematic, suboptimal decisions in behavioural newsvendors could be due to over-focusing on the big picture and neglecting rare events. Accordingly, both academicians and practitioners should revisit the design of decision support systems as well as competitive strategies that involve human decision making against large number of uncertain future outcomes.

Keywords: newsvendor; risk and uncertainty; prospect theory; decision weight; probability weighting; pull to center; behavioral operations;

JEL Classification: M11, M21, D21, D22

Suggested Citation

Huang, Xiao and Nagarajan, Mahesh and Guo, Shanshan, Probability Weighting and the Newsvendor Problem: Theory and Evidence (October 6, 2021). Available at SSRN: https://ssrn.com/abstract=3937363 or http://dx.doi.org/10.2139/ssrn.3937363

Xiao Huang (Contact Author)

John Molson School of Business, Concordia University ( email )

1455 de Maisonneuve Blvd West
Montreal, Quebec H3G 1M8
Canada

HOME PAGE: http://www.xiaohuang.ca

Mahesh Nagarajan

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Shanshan Guo

Shanghai University of Finance and Economics

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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