The Role of Emotion in the Newsvendor Problem

The newsvendor problem is a foundational model for decision making in inventory and supply chain management. In its simplest form, the newsvendor must decide how many units to order of a perishable product that has stochastic demand. This single-period inventory problem sets the groundwork for more complex inventory decisions and has relevant applications in a diverse set of business fields such as capacity allocation, revenue management, and staffing in service industries. The optimal policy prescribing the order quantity that maximizes the expected profit is well documented. Not surprisingly, behavioral studies have found that human decision making deviates from the rational expected-profit-maximizing order. Interestingly, however, two systematic patterns arise when people make these decisions and have been replicated across multiple studies for almost two decades. First, when individuals adjust their order quantity over consecutive periods, they tend to do so in the direction of the most recent demand realization. This phenomenon is commonly referred to as demand-chasing. Second, when order quantities are averaged across periods, they tend to fall between mean demand and the optimal order quantity. This pattern has come to be known as the pull-to-center effect. Existing literature suggests dispositional factors, like whether people tend to follow an anchoring and insufficient adjustment heuristic, may explain these patterns. However, these studies have primarily assumed an observer’s perspective and have failed to identify what the cognitive mechanism that explains why people choose a particular order quantity is. Supporting this claim, a recently published literature survey concluded that there is a lack of understanding of what the cognitive processes that drive ordering behavior are and hence, it is unclear what the underlying explanation for these effects is. This dissertation addresses these shortcomings in two essays. The first essay focuses on demand-chasing. By considering the actor’s perspective, we show that the situation in which decisions are made in the newsvendor problem explains why people chase demand, and thus dispositional inferences are unwarranted. In an experimental setting, we test our hypotheses which are based on counterfactual thinking theory and find that decision makers experience a negative cognitive-based emotion—regret—, and this emotion predicts demand-chasing behavior. The second essay focuses on the pull-to-center effect. Having identified, in our first essay, a crucial cognitive mechanism through which ordering behavior can be explained, we develop hypotheses describing the influence such mechanism has on average order quantities being pulled-to-center. Results show that as decision makers chase demand their average order quantity is more pulled-to-center, but this effect is contingent on the level of knowledge individuals have about the newsvendor problem. In conjunction, these essays provide a comprehensive understanding of decision making in the newsvendor problem by identifying a cognitive-based emotion resulting from situational factors and showing how it affects ordering behavior in the form of demand-chasing, which in turn affects aggregate level patterns and performance. The theoretical implications of this dissertation focus on explaining why people order what they do and providing a single unifying mechanism through which past findings can be interpreted and reconciled. The practical implications focus on specific managerial actions that help mitigate the deleterious effects of self-blame that occur when people regret the choice they made.