Observation Bias: The Impact of Demand Censoring on Newsvendor Level and Adjustment Behavior

In an experimental newsvendor setting where 310 subjects make 50 repeated newsvendor decisions with the same known ex-ante parameters, we investigate three phenomena: Level behavior – the decision-maker’s average ordering tendency; adjustment behavior – the tendency to adjust period-to-period order quantities; and observation bias – the tendency to let the degree of demand feedback influence order quantities. We measure ordering behavior in terms of decisions (quantities) and performance (expected mismatch cost). We find that the portion of mismatch cost due to adjustment behavior exceeds the portion of mismatch cost due to level behavior in three out of four conditions, highlighting the importance of considering order adjustment in addition to level behavior, which has thus far received more research attention. Observation bias is studied through censored demand feedback, a situation which arguably represents the majority of newsvendor settings. When demands are uncensored, subjects tend to order below the normative quantity when facing high margin and above the normative quantity when facing low margin, but in neither case beyond mean demand (a.k.a. the pull-to-center effect). Censoring in general leads to lower quantities, magnifying the below-normative level behavior when facing high margin but partially counterbalancing the above-normative level behavior when facing low margin, violating the pull-to-center effect in both cases. May 2009, revised August 2010