Prospect Theory and Location Covering Model

Merve Uslu, Mustafa Uyank Izmir University of Economics, Logistics Management Department
This paper explains about implementation of prospect theory on location covering activity model in logistics management. There is no former study or research that links the prospect theory and location covering. Hence, this paper as a forerunner is significant for lighting the way for the studies include prospect theory and logistics management activities together. In this paper, we examine the simple location covering model with its outputs. Then, we develop the model incorporates the human behavior and responds accordingly to analyze how the prospect theory affects on decision making for location covering model.

1. Introduction
Logistics is a tool in the supply chain which meets all the needs of customers like goods, service, and information flow from supplier to end consumer at the right time, to the right place with the right cost and the right amount. Main logistics activities consist of customer service, demand forecasting, distribution communications, inventory control, material handling, order processing, parts and service support, plant and warehouse location, procurement and packaging, traffic and transportation, warehousing and storage which are required to be controlled effectively and efficiently in the supply chain. While performing these activities, optimization is the motive for decision makers. However, these models are constructed and implemented without considering human behavioral effects. Therefore, results of the models are not accurate enough and cause to face with unexpected and unpredicted results. Behavioral effect is a late player for many fields, as such, economics, finance, etc. However, new perceptions expand the scope of studies. In addition, after taking human behavior into account, the outputs of the models become more realistic. We test, how a human behavior affects the one particular model step by step addressing the prospect theory. The organization of the paper is as follows: In section 2, literature review covers academic research about implementation of prospect theory and logistics models. In section 3, problem selection and definition, and explains an illustrative example of the model. The last section is as a conclusion.

2. Literature Review
Kahneman and Tversky (1979) develop the prospect theory model which is related with decision makers behavior under risky situations. According to the article, the definition of prospect theory is Decision making under risk can be viewed as a choice between prospects or gambles. (Kahneman and Tversky, 1979). The prospect theory is a widely studied area but the focus is mainly on financial behaviors and economy. A hypothetical value function explains the deviation of reference point as gains (concave) and losses (convex). The S- shaped value function is the steepest at the reference point and is considerably steeper for losses than for gains.

Figure 1 A hypothetical value function (Source: Kahneman and Tversky, 1979)

Ho and Perl (1995) explain the warehouse location model related with referring the most critical factors of distribution network design and customer service. This article analyzes how the effects of customer demand and service to define warehouse location. Ho and Perl (1995) dont justify an implementation of empirically test to determine location decision. They use assumptions to analyze the effects the numbers of warehouses, assignment of warehouses to supply sources, allocation of demand to warehouses, product availability, and order cycle time for customer service affect to determine location decisions. However, Boudreou et al. (2003) implements quantitative models on simplified behavioral assumptions to discuss mathematically. Bouzdine (2011) evaluates the risks and benefits of the prospects theory application on the bio wines. The study facilitates to understand how risky choices, environmental risks, quality risks, supply chain risks and market risks, can be examined using the prospect theory. They specify to analyze the alternatives having the highest utility and additional costs which are bio or not bio, bio certified or not certified, and reasonable use of chemicals. According to these three alternatives, they implement the impacts on prospect theory on success, sales, investment decision, and net profit. We examine how reference dependence point of the s-shape value function explains in detail loss aversion and sensitivity in price preferences of airway passengers in between absolute prices and reference prices. (Nicolau, 2011). These two studies Bouzdine (2011) and Nicolau (2011) focus on measure the feasibility of prospect theory on financial behavior in terms of the potential decisions. Tokar (2010) shows that behavioral experiments in logistics have not a common research area in the literature, so he analyzes the importance of behavioral approaches in logistics and supply chain management referring to lack of previous studies. However, in recent years, some researchers develop frameworks to respond complexity about behavioral issues in logistics activities and supply chain management. These frameworks provide to be more specific for our research especially the framework designed by Bendoly et al. (2006) defines our specific objective that implements on prospect theory.

3. Problem Selection and Definition

We examine which logistics activity can be implemented to analyze how human behavior affects to objective function of decision model. Bendoly et al. (2006) develop a framework which includes identification and classification of behavioral activities in existing models and clarification for judgments and causes of potential decision-making models. (Tokar, 2

2010). We create some assumptions for the framework which classes decision makers in terms of their intention, action and reaction. Because, this framework is an easy way to understand which logistics activity should be researched for analyzing human behavior effects. We adopt the method three problems: fleet composition, location covering, and vehicle allocation. We explain the general objectives of decision makers and unexpected possible behavioral gaps for these objectives in the intention part. The action part includes rules and behaviors of the logistics activity, as such, individual attributes and ability to work. The last part, reaction, includes assumptions about how the decision makers can reorganize regards to the changes and how people reacts these changes. In the intention part of location covering model, as a common modeling assumption, managers may avoid expansion of service area to service at desired time with a minimum cost. However, they fail to notice that less operating sites cause to increase burden of work and complexity. As an action, they assess rationally to cover the routes due to enhance customer satisfaction in desired period of time. But, managers can show a tendency to have sites that are closer to residences and stores. In reaction part of common model assumption, if the service is provided in desired period of time, all people are satisfied at the same level. However, as a possible behavioral gap, people may not satisfy at the same level, because less number of sites may create doubts in views of people. In fleet composition model, generally, when managers make decisions of hiring trucks, they prefer to pay total cost at minimum level. However, the past relationship between firms may be an obstacle to choose the efficient and unbiased decision. They generally analyze the risks and costs of trucks base on some indicators and data, but trucks that can be preferable in terms of having experienced driver over other choices even if they have higher cost. As a reaction in general, sending back hired trucks are available randomly at a desired time. Nevertheless, when managers hire the trucks for the short term or at a required time instead of randomly, this behavior may seem as unethical in the business life. Common modeling assumptions of vehicle allocation problem, managers accept or reject demands to make a maximum profit. However, when managers choose between identical loads in terms of travel time, unit and profit per unit, they may choose the load with less unit value for avoiding possible damages occur during shipment. In action part, they make trucks to wait in their destination point or calling back them to meet another demand. However, they fail to notice that the waiting cost of the vehicle in some areas may have higher cost than returning it. They react as considering that all the rejected demand is worth rejecting in general, but some demands may worth to be altered with one of the accepted demands but has not been performed yet. According to this study, we decide to focus on location covering model because it is more dependent on human behaviors than other models and it is easy to examine. In the light of these we study to measure impacts of the prospect theory in the location covering model as comparing differences between current service level and forecasted service level.

Table 1: Example of IAR framework applied to logistics models Logistics Models Location Covering Common Modeling Assumptions Intention Minimizing the operating sites with reaching the desired service time. Less operating sites may lead high burden of work & complexity & insufficiency in workplace. Assumptions Categories Action Routes to be covered are assessed rationally. Reaction People are OK if they are satisfied in desired period of time. The satisfaction level of people is not the same even if its in the given period of time. Also less number of sizes may raise doubts in views of people.

Possible Behavioral Gaps

Tendency to have more attention on sites that has more residences and stores etc.

Fleet Composition Common Modeling Assumptions

Intention Make decisions with goal of min. total cost.

Action Risks & costs that related to trucks are assessed.

Reaction Firing trucks is available when desired and firing them is allowed randomly.

Possible Behavioral Gaps

Past relationship with the truck hiring firms may affect the choices among firm.

Choosing the newer and or experienced driver over the old truck even it has relatively higher cost.

Hiring for short term agreements or when needed is not allowed may seem unethical in work environment.

Vehicle Allocation Common Modeling Assumptions

Intention Accepting & rejecting demands and repositioning vehicles to max. profit & revenues. Choosing the less valuable load among the identical demands in terms of travel time, unit and profit per unit.

Action Vehicle waiting or reallocating it to another demand. Waiting cost in a particular area may be more costly than returning it.

Reaction All the rejected demand is considered worth to reject

Possible Behavioral Gaps

Some demands may worth to be altered with one of the accepted but not performed demands.

3.1. Illustrative Example The logic behind location covering is satisfying every customer in a geographical area within a period of time. Activity of ambulances and fire-fighters is one of the best examples to clarify the location covering. In this sense, there are certain demand points in an area and these demand points are also candidates of potential service sites. The objective is to minimize the number of operating sites while serving all customers. A secondary objective can be minimizing total service times provided to customers. 4

The following example demonstrates how consideration of human behavior factor changes the outputs of a simple model. We will explain every development in the model step by step. Beginning with a simple location covering model: Let; V: A, B, C, D, E, F and G are both demand points and candidates of potential service sites. i,j V : Service time from i to j. T: 15 minutes (desired service time level) :{ : Fixed cost of opening of site i. :{ : Existing service level. : New service level.
Table 2: Service Time Table in Minutes

A A B C D E F G 11 20 16 7 9 16

14 15 18 20 19 29 27 12 5 9 21 28 12 9 7 -

Objective Minimize Subject to

| |

{0,1} ,

{0,1}

The first part of the objective function is the minimizing the fixed cost of operating sites. The second part minimizes the service times from i to j. First constraint provides serving all customers within 15 minutes. The second one provides the dependence of serving from site only if it is opened. Third constraint, obliges that all sites must be covered within 15 minutes. The last constraint assures that one site is covered within 15 minutes for once. The output of this model is choosing the operating sites of C and E with the service levels of covering; A=7, B=14, C=0, D=9, E=0, F=12, G=5 If we consider this as a current model and want to apply some changes in order to make it better and monitor scenarios, there will be changes in service levels or in the choice of optimal solution. If we determine T=12; the result will be choice of B,E,G as operating sites with the levels of : A=7, B=0, C=5, D=9, E=0, F=7, G=0 We got two different outputs for two different desired service level times. Considering the preferences of people get served, whether new service level is better than the previous one or vice versa, we must monitor the changes in the service level provided to each demand point. We add, and positive variables to monitor the service level time changes in model while the desired service level time decreased or increased. Improvement in the service levels provided is important in the eyes of people served to make them pleasant. On the other hand, the deterioration in the service levels makes people more unsatisfied. Hence, we add objective function the equation for weighting the and . As we have more willingness not to have negative changes in service level, the importance of going bad denominated with higher weight. ( > ) New Objective Function Minimize Subject to 6

| |

{0,1} ,

{0,1}

The new constraint that is different from the first model provides the monitor the good or bad changes as it preserves the equation from resulting negative. After setting 12 minutes as desired service level into objective of second iteration, positive (good) changes are: 14 units in B, 5 units in F and 5 units in G. However, there is a negative (bad) change in C with 5 minutes. In addition, the choice of operating sites for T=12, was B,E andG before. After weighting and adding the and , the result is choosing B,C and E. One of the operating sites is altered when considering human behavior. We designed the model considering the human behavior so far. We applied the aspects of Figure.1 into our model, as loss part of the graphic is steeper; our model is more sensitive not to make deterioration in service level. However, after a certain amount of change human preferences become numb. Beyond these levels, it is just good or bad. The following figure shows the situation.

Figure 2. Value Function

We determine this numb level as half of the desired service level (T) which is 6. So, improvements and deteriorations in service level provided to customers should not be important for the model. When we type the new constraints of and cannot exceed 6, the model started to ignore making improvements beyond 6, which was the case in demand point B with an improvement level of 14. In order to put this idea into the model, we add two additional positive variables and three additional constraints. : Additional amount of improvement in service level provided beyond 6. : Additional amount of deterioration in service level provided beyond 6. 7

New Objective Function Minimize Subject to | |

{0,1} ,

{0,1}

The last constraint is for assigning value for and when there are values exceeding 6 for and . It also preserves equation resulting negative. In the last part of the objective function the weights of inferior than and just because making and and are denominated prior in taking values.

When we run the model, it selects A, C and E as operating sites. The service levels are: A=0, B=11, C=0, D=9, E=0, F=9, G=5 Positive (good) changes are: A= 6, B=3, F=3. There is one unit of additional positive change in demand point A. In addition, there is no negative (bad) change. The Gams Code of this model development is in Appendix. The human behavior affect derived from Prospect Theory, altered the outputs of such a simple model. The changes in outputs for every modified model are in the following table.

Table 3: Service Time Table

A B C D E F G Conclusion

T=15 M 7 14 9 12 5

T=12 M 7 5 9 7 -

T=12 M 7 9 12 5

The S-shape function of Prospect Theory, Kahneman and Tversky (1979), is the bottom line of our study. This study enhances our understanding of implementation of prospect theory on a wide range of area. The most important limitation is the fact that lack of studies about measurement of human behavior effects in the logistics activities. This paper remarks the significance of taking human behavior into consideration while constructing the optimization models and demonstrates its altering effects on results. We aim to analyze the location covering model for incorporating the human behavior more obvious and not being a complex model. Even the most general and limited model of location covering in terms of size, helps to examine the differences that human behavior constraint made. The model that we develop enables decision makers to add human behavior factor in the objective function. In this study, we take in hand very basic location covering model and developed it step by step to form into model that considers the human behavior effect. Further research regarding the human behavior in optimization models can be warehouse selection, shipment consolidation and dispatching, supplier selection etc. All of these activities include human behavior and preferences. The analysis of each activity regarding the human behavior like in our study is crucial for having more realistic results instead of just optimal results.

Acknowledgement: This paper is written for the course LOG460 Directed Research offered Fall 2011 and the academic advisor is zgr zpeynirci.

References

Bendoly, E., Donohue, K. and Schultz, K.L. (2006), Behavior in Operations Management: Assessing Recent Findings and Revisiting Old Assumptions, Journal of Operations Management, Vol. 24 No. 6, pp. 737-752. Boudreau, J., Hopp, W., McClain, J.O., Thomas, L.J. (2003), On the interface between operations and human resources management, Manufacturing and Service Operations Management, Vol. 5 No. 3, pp. 179-202. Bouzdine, T. (2011), More risks or/and more benefits? Prospect Theory application to the analysis of the bio wines evolution in France, 6th AWBR International Conference. Bordeux Management School. Ho, PK., Perl, J. (1995), Warehouse Location under Service-Sensitive Demand, Journal of Business Logistics, Vol. 16 No. 1, pp. 133-162. Kahneman, D., Tversky A. (1979), Prospect Theory: An Analysis of Decision under Risk, Econometrica, Vol. 47 No.2, pp. 263-292. Nicolau, J., L. (2011), Testing prospect theory in airline demand, Journal of Air Transport Management, Vol. 17, pp. 241-243. Tokar, T. (2010), Behavioral Research in Logistics and Supply Chain Management, The International Journal of Logistics Management, Vol. 21 No. 1, pp. 89-103.

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