Judgmental forecasting in the presence of loss functions

Many practicing forecasters operate in an environment where there are either implicit or explicit biases favouring under- or over-forecasting. For example some marketing executives may be rewarded for exceeding the forecast which operates, in effect, as a sales target. In other organizations, the forecast may be set high to encourage greater effort. Previous studies show that most practical forecasts are indeed significantly biased, with some organizations biased one way and some the other. One of the possible reasons for this bias is the rational reaction to asymmetry in the loss function faced by the forecaster. This paper reports a laboratory study on the reactions of forecasters to different types of loss functions. The subjects were given a cover story that they were the production manager in an organization with an asymmetric loss function. This was diagrammatically displayed, and operationalised in the experiment by paying money bonuses to the subjects. Two shapes of loss function were used differing in their kindness, and two directions of bias, one favouring over- and one under-forecasting. The results show that the subjects responded appropriately to the differing kindness shapes of the loss functions. These results support the field research showing that forecast biases can be the result of deliberate and rational decision making behaviour on the part of the forecasters.