An Experimental Investigation of Auditors' Liability: Implications for Social Welfare and Exploration of Deviations from Theoretical Predictions

Abstract

This paper reports the results of an experiment designed to investigate how legal regimes affect social welfare. We investigate four legal regimes, each consisting of a liability rule (strict or negligence) and a damage measure (out-of-pocket or independent-of-investment). The results of the experiment are for the most part consistent with the qualitative predictions of Schwartz's (1997) model; however, subjects' actual choices deviate from the point predictions of the model. We explore whether these deviations arise because: (1) subjects form faulty anticipations of their counterparts' actions and/or (2) subjects do not choose the optimal responses given their anticipations. We find that subjects behave differently under the four regimes in terms of anticipation errors and departures from best responses. For example, subjects playing the role of auditors anticipate investments most accurately under the regime with strict liability combined with out-of-pocket damages, but are least likely to choose the optimal response given their anticipations. This finding implies that noneconomic factors likely play a role in determining subjects' choices.