On the comparison of risk-neutral and risk-averse newsvendor problems

Abstract

The objective of this paper is to investigate and compare the relationship between risk-neutral and risk-averse newsvendor problems under three different decision criteria: expected utility (EU) maximization, mean-variance (MV) analysis, and conditional value-at-risk (CVaR) minimization. Several models in the literature have shown that for special cases of the newsvendor problem (eg, no salvage value, no shortage penalty, and with recourse option), a risk-averse newsvendor orders less than a risk-neutral newsvendor. First, we present an observation about the EU maximization models with such special cases where a risk-averse newsvendor orders less than a risk-neutral one. We note that this observation does not extend to the newsvendor problem with positive shortage penalty. Using several counterexamples, we demonstrate that the common wisdom that a risk-averse newsvendor orders less than a risk-neutral newsvendor is not true in general. Second, we demonstrate, analytically where possible and numerically if not, that the comparison of the optimal order quantities of risk-neutral and risk-averse newsvendors depends on the key assumptions regarding the model inputs, namely, the decision criterion, the demand distribution and the cost parameters such as shortage penalty and unit ordering cost. Third, we show that EU and the MV criteria yield consistent results while EU and CVaR criteria may yield consistent or conflicting results depending on the loss function used for the CVaR criterion.

Keywords:

• conditional value-at-risk
• expected utility theory
• risk-aversion
• newsvendor model

Acknowledgements

This research has been supported in part by NSF Grants CMMI-0621097 and CMMI-1131756.