The newsvendor model with non-zero reference point based on cumulative prospect theory

Abstract

This paper formulates the newsvendor model with a non-zero reference point based on cumulative prospect theory (CPT-based newsvendor model), evaluating the prospect by a piecewise-linear value function (ModelPL). We prove the concavity of the objective function, and therefore, the model is solved by the first-order optimality condition. As a comparison, we further present the newsvendor model based on a piecewise-exponential value function (ModelPE), where the utility curvatures are considered.The results show that for a low-profit item, only ModelPE can explain the “pull to center” effect that was found by Schweitzer and Cachon (2000), if the reference point is high enough. However, for a high-profit item, both models successfully predict the newsvendor’s behavior if the newsvendor conceives a non-zero reference point. Thus, prospect theory (PT) should not be excluded as a potential explanation for the “pull to center” effect of the newsvendor’s decision.