Designing Buyback Contracts for Irrational but Predictable Newsvendors

One of the main assumptions in research on designing supply contracts is that decision makers act in a way that maximizes their expected profit. A number of laboratory experiments demonstrated that this assumption does not hold – specifically, faced with uncertain demand, decision-makers place orders that systematically deviate from the expected-profit maximizing levels. We add to this body of knowledge by demonstrating that ordering decisions also systematically depend on individual contract parameters, and developing a behavioral model that captures this systematic behavior. We proceed to test our behavioral model with two different experiments, and use the data to derive empirical model parameters for individual subjects. We then test our approach in an additional out-of-sample experiment that confirms that indeed, contracts designed using the behavioral model perform much better than contracts designed using the standard model