An experimental investigation on optimal bankruptcy laws

Abstract

We performed an experimental investigation to assess whether the “restricted auction” mechanism proposed by Berkovitch, Israel and Zender in 1997 works effectively as an optimal bankruptcy law or not. An optimal bankruptcy law is a commitment device that implements efficient choices both before (ex ante) and after (ex post) financial distress, even if moral hazard is binding. We designed an experiment focused on ex ante efficiency and we found that the restricted auction mechanism was able to direct an optimal amount of effort toward entrepreneurial activities. This result confirms the theoretical predictions. Nonetheless, we found that under a plain unrestricted auction mechanism our experimental subjects chose to allocate into their firms a larger amount of effort than that predicted by theory. Although difficult to justify on theoretical grounds, this experimental evidence is robust. Our behavioral interpretation is that this result is due to “moral sentiments”, such as the natural propensity of subjects toward socially desirable behaviors. In fact, we show that it vanishes once these motives are removed.