Paccar Hall, Room 292

SPEAKER: Bardia Kamrad
AFFILIATION:  Georgetown University
AREA:  Operations Management

TITLE: Newsvendor Model as an Exchange Option on Demand and Supply Uncertainty 

ABSTRACT:
Using a contingent claims framework, we develop a single period model in the context of an exchange option in a discounted net present value maximization milieu. Given this framework, we study the classic problem of determining stockpiling levels prior to demand realization and when procured (or produced) levels are subject to random yield variations. However, revenues are based on usable levels only. Both demand and yield variables are modeled as Wiener processes. Uncertainty in yield dynamics are initially modeled by a pure noise process. Later, we explore the prospect of improving the average yield rates, subsidized by increasing unit costs in a constrained cost environment and establish an upper bound on improvement rates. In either case, “yield adjusted” critical fractiles and the resulting optimal order (or production) levels and corresponding expected net present values are established. We demonstrate the counter-intuitive results that per unit profits, as a consequence of improved average yield rates may actually decline relative to a pure noise model. Using these results, we show that a reliable metric in justifying yield improvement is the relative marginal unit profit. That is, improving yield on an average basis when compared to a pure noise case is only economically practical when the resulting marginal unit profits justify constrained expenditures. Our results provide additional useful insights for policy making by identifying operating regions where the expected relative marginal unit profits are support improving average yield rates.