Pricing behavior, effort choices, and settlement offers under alternative legal cost allocation systems: Evidence from an auditing game

Abstract

Abstract This paper reports the results of two experiments, each consisting of six sessions, designed to investigate seller behavior in an auditing game. Across the two experiments, we vary the legal cost allocation rule. In experiment one, the seller must pay his or her legal costs regardless of the outcome of litigation (the American rule). In experiment two, the seller must pay his or her legal costs (and the buyer's legal costs), but only if the seller is liable for damages suffered (the British rule). Within each experiment, we investigate whether the seller's behavior (effort choices, fee offers, and settlement offers) is consistent with game theory or behavioral theory. Across the two experiments, we investigate whether differences arise in behavior, which may be attributable to the legal cost allocation system. Our findings, in general, provide little support for the game theory, directional predictions. Effort choices in experiment one are consistent with such predictions, but otherwise little support is found. By comparison, fee behavior across the two experiments is consistent with behavioral theory. The seller's direct cost appears to be focal in determining fees. Across the two experiments, we find that fee offers include a higher premium, above the competitive price, under the American rule than the British rule. In addition, we find that settlement offers are more likely to be optimal under the British rule than the American rule.