How increasing relative risk aversion affects retailer orders under coordinating contracts

Abstract

We analyze how risk aversion affects the order-quantity decisions of a retailer for two coordinating contracts - buyback and real option. The retailer faces uncertain customer demand and makes a single order-quantity decision to maximize expected utility. We show that for a retailer with increasing relative risk aversion, orders decline in the expected profit share of the supply chain, which is determined by the parametrization of the contract. We use an exponential utility function to model a retailer with increasing relative risk aversion and test our model on existing experimental data as well as on data from a validation experiment. In our validation experiment, we link order quantities to certainty equivalents and establish risk aversion as an underlying cause for the deviation from profit maximizing quantities. Additionally, we find that under real option contracts, risk averse retailers order more than under buyback contracts.