The loss-averse retailer's order decisions under risk management

Abstract

This paper characterizes the retailer's loss aversion by introducing a loss aversion coefficient and proposes a new loss aversion utility function for the retailer. To hedge against the risk arising from the uncertain market demand, we use the Conditional Value-at-Risk (CVaR) measure to quantify the potential risks and obtain the optimal order quantity for the retailer to maximize the CVaR objective of loss aversion utility. It is shown that that the optimal order quantity for a retailer to maximize the expected loss aversion utility is smaller than expected profit maximizing (EPM) order quantity in the classical newsvendor model, which can help to explain decision bias in the newsvendor model. This study shows that the optimal order quantity with the CVaR objective can decrease in retail price under certain conditions, which has never occurred in the newsvendor literature. With the optimal order quantity under the CVaR objective, it is proved that the retailer's expected loss aversion utility is decreasing in the confidence level. This confirms the fact that high return means high risk, while low risk comes with low return. Based on the results, several management insights are suggested for the loss-averse newsvendor model.