The loss-averse newsvendor problem with supply options

Abstract

In this article, we consider a loss-averse newsvendor with stochastic demand. The newsvendor might procure options when demand is unknown, and decide how many options to execute only after demand is revealed. If the newsvendor reserves too many options, he would incur high reservation costs. Yet reserving too few could result in lost sales. So the newsvendor faces a trade-off between reservation costs and losing sales. When there are multiple options available, the newsvendor has to consider how many units of each to reserve by studying the trade-off between flexibility and costs. We show how the newsvendor's loss aversion behavior affects his ordering decision, and propose an efficient algorithm to compute his optimal solution in the general case with n options. We also present examples showing how the newsvendor's ordering strategy changes as loss aversion rises.