Thursday, August 21, 2014

On the Consistency between Prospect Theory and the Newsvendor Pull-to-Center Effect

UPPARI Bhavani Shanker, HASIJA Sameer
Read the working paper
INSEAD Working Paper 2014/50/DSC/TOM

This paper revisits the role of prospect theory in explaining the pull-to-center effect that has been consistently observed in laboratory experiments addressing the newsvendor decision problem. Our results contrast with the extant literature, most of which uses a zero-profit reference point in prospect theory models. We use that same literature to establish the salience of mean demand in newsvendor decisions and show that, when one uses the outcome associated with that decision as a reference point, prospect theory cannot be ruled out as an explanation for the pull-to-center effect.