Sourcing decisions with loss aversion under yield and demand randomness

Abstract

Yield and demand randomness are common in the industry, and loss aversion has been regarded as an inherent behavior for decision-makers. We combine these two factors and investigate a retailer’s ordering decisions under both yield and demand randomness with loss aversion. Before the selling season, the demand is unknown and the loss-averse retailer places an order from an unreliable supplier with an uncertain yield rate. After the demand and supply from the unreliable supplier are known, the retailer can carry out emergency replenishment from a spot market during the selling season. We characterize the retailer’s optimal ordering decisions in three scenarios: (1) the retailer is risk-neutral; (2) the retailer is loss-averse and has a zero reference profit; (3) the retailer is loss-averse and has a nonzero fixed reference profit (FRP). We compare the retailer’s order quantities in the three scenarios and find that the order quantity of the loss-averse retailer with a zero reference profit is always lower than that of the risk-neutral retailer. However, the order quantity of the loss-averse retailer with a nonzero fixed reference profit is higher than that of the risk-neutral retailer when the salvage value is sufficiently large. Interestingly, we find that the loss-averse retailer’s optimal order quantity decreases with the reference profit and increases with the loss-averse degree and the maximum fulfillment rate from the unreliable supplier under some conditions. We investigate these conditions under a uniform demand distribution. We further study the ordering quantity of the retailer with a prospect-dependent reference point (PRP) and compare the results under FRP and PRP.