Behavioral demand effects when buyers anticipate inventory shortages

Firms often worry about how buyers will react when there is an inventory shortage, but the anticipation of facing a shortage may also impact buyer behavior. In this paper we use a combination of theoretical modeling, computational methods, and laboratory experiments to understand buyers’ search behavior in markets where there is potential for either a costly or costless inventory shortage. When inventory shortages are costly to buyers we find their equilibrium purchasing strategy generates a newsvendor problem among the firms. In turn, experimental data suggests buyer behavior can be explained by prospect theory better than by standard assumptions of fully rational expected utility maximizing agents, indicating that potential inventory shortages generate loss aversion among buyers, and there is systematic mis-identification of the probability with which they will be able to procure an item. Using computational methods, we find firms are able to extract more surplus from behavioral buyers via higher prices than would be predicted by the standard model. On the other hand, when inventory shortages are not costly to buyers the effect of behavioral biases on the part of buyers is not relevant. But in this case there can be a benefit to reducing inventory via a reduction in price competition.