Coping with Loss Aversion in the Newsvendor Model

Abstract

We introduce loss aversion into the decision framework of the newsvendor model. By introducing the loss aversion coefficient λ, we propose a novel utility function for the loss-averse newsvendor. First, we obtain the optimal order quantity to maximize the expected utility for the loss-averse newsvendor who is risk-neutral. It is found that this optimal order quantity is smaller than the expected profit maximization order quantity in the classical newsvendor model, which may help to explain the decision bias in the classical newsvendor model. Then, to reduce the risk which originates from the fluctuation in the market demand, we achieve the optimal order quantity to maximize CVaR about utility for the loss-averse newsvendor who is risk-averse. We find that this optimal order quantity is smaller than the optimal order quantity to maximize the expected utility above and is decreasing in the confidence level α. Further, it is proved that the expected utility under this optimal order quantity is decreasing in the confidence level α, which verifies that low risk implies low return. Finally, a numerical example is given to illustrate the obtained results and some management insights are suggested for the loss-averse newsvendor model.