Prospect Theory and the Newsvendor Problem with Mental Accounting

Abstract

The manner in which economic outcomes are coded in a value function is critical because it has substantial influence on the evaluation of risky choices. In this paper, we formulate multiple mental accounts in a nonlinear value function and propose a newsvendor problem with mental accounting to predict and explain pull-to-center phenomenon. We show that the distinctive predictions of the proposed model come from the value function with mental accounting. We identify the individual and combined effects of loss aversion, risk aversion, and risk seeking on shaping newsvendor ordering behavior. Our work demonstrates that prospect theory can explain the decision bias and ordering behavior observed in newsvendor experiments. We also provide some additional insights to explain the studies in the literature.

Keywords

Prospect theory / mental accounting / newsvendor problem / decision bias / pull-to-center phenomenon

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