Prospect Theory Explains Newsvendor Behavior: The Role of Reference Points

Current understanding in operations management is that prospect theory, as a theory of decision making under uncertainty, cannot systematically explain the ordering behavior observed in experiments on the newsvendor problem. We suggest this is because the newsvendor’s reference point is assumed to be the status quo, i.e., zero payoff. We propose an alternative based on newsvendor’s salient payoffs and show that prospect theory can, in fact, account for experimental results. This paper was accepted by Serguei Netessine, operations management.