Abstract: In this paper, we examine firms’ quality and inventory decisions with consumers who behave heterogeneously not only on the product’s valuation (horizontal) but also on the reference price setting (vertical). Through a three-stage Stackelberg leader-follower model, we derive cost-effective solutions for channel members in two distribution scenarios. Counter-intuitively, the analytical result illustrates that profit-maximizing inventory and quality decisions can be higher when the uncertainty of the market increases because the two-dimensional impacts of market uncertainty on demand are diametrically opposite to each other. Specifically, the vertical uncertainty (difference in reference effects) has a buffering effect on the aggregate market demand, which is further amplified by loss-aversion behaviors. However, the horizontal uncertainty (heterogeneity of consumer valuation) has a promoting effect on the market demand and induces firms to order more. The numerical result further shows that market demand may not inherit the behavioral bias of individual consumers, leading to an inconsistent relationship between the sensitivity of market demand to gain/loss and consumers’ loss-aversion behaviors. Our findings have implications not only for understanding the stochastic market demand with behaviorally biased consumers but also for determining the channel members’ optimal inventory and quality decisions.

Key words: aggregate market demand, loss-averse market, product quality and inventory, newsvendor model, distribution channel