Working Papers

Risk-averse Newsvendor Networks: Resource Flexibility, Sharing, and Hedging
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Jan A. Van Mieghem
March 2004 (revised January 2006)

Abstract

This paper studies how differences in risk exposure and risk attitude affect network configuration. Theory is presented for general utility functions and their mean-variance approximations and illustrated with networks featuring inventory substitution and commonality, or resource sharing and flexibility.

When faced with increased risk exposure, risk-neutral newsvendors change resource levels proportionally to standard deviations, but risk-averse agents adjust proportionally to variance. While single-resource risk-averse newsvendors always invest less than risk-neutral newsvendors, they may invest more in networks. Not only may some resource levels increase in risk aversion, even the entire monetary network investment may exceed its risk-neutral counterpart. Two drivers explain this operational hedge, suggesting rules of thumb for strategic placement of safety capactiy and inventory in networks. With strongly negative correlations, diversification (risk pooling) suggests to increase inexpensive resources that supply lower profit variance products. This highlights the role of profit over demand variance in risk-averse network design. With product profit difference, revenue maximization suggests to increase (decrease) parallel (serial) flexibility. These insights confirm and refine the intuitive notion of safety capacity/inventory and flexibility as an operational hedge to mitigate risk.

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