Decision making under information asymmetry

We examine how people make decisions when the value they derive from those decisions depends on the response of a less informed party. Such situations are common, but they are difficult to analyze because of the plethora of justifiable equilibrium outcomes that result. To address this, researchers employ belief refinements, which pare the set of the equilibrium outcomes by imposing assumptions on how people form their beliefs. The choice of which refinement to use is critical because it can lead to dramatically different predicted outcomes. To better understand which refinement is more predictive of actual behavior, we conduct a controlled experiment in a setting central to operations management--a capacity investment decision. We test whether subjects' decisions are consistent with those predicted by the Intuitive Criterion refinement, which is based on equilibrium domination logic, or the Undefeated refinement, which is based on Pareto optimization logic, and find the Undefeated refinement to be considerably more predictive. This is surprising because the Intuitive Criterion refinement is the most commonly utilized belief refinement in the literature while the Undefeated refinement is rarely employed. Our results have material implications for both research and practice because the Undefeated and Intuitive Criterion refinements often produce divergent predictions. We show that subjects are particularly more likely to make decisions consistent with the Undefeated refinement if they report a higher understanding of the decision setting. This supports the use of the Undefeated refinement in operations management research, which often assumes that decision makers are rational and understand the implications of their choices.