Impact of loss aversion on the newsvendor game with product substitution

Abstract

Abstract This paper studies a newsvendor game in which two substitutable products are sold by two different retailers (newsvendors) with loss-averse preferences. Each loss-averse retailer facing stochastic customer demand and deterministic substitution rate will make an order quantity decision to maximize his expected utility. Since product substitution causes two retailers to make decisions in a competitive environment, game theory is used to find the retailers' optimal order quantities. It is shown that under certain conditions, there exists a unique Nash equilibrium in the newsvendor game. Under a symmetry assumption, each retailer's equilibrium order quantity is decreasing in the loss aversion coefficient and increasing in the substitution rate. Further, if the effect of loss aversion on the order quantity is strong enough to dominate the effect of competition, the total inventory level of a decentralized supply chain will be lower than that of a centralized supply chain. Numerical experiments are conducted to illustrate our results.