On the investment implications of bankruptcy laws under sequential investment decisions

Abstract

Axiomatic analysis of bankruptcy problems reveals three major principles: (i) proportionality (PRO), (ii) equal awards (EA), and (iii) equal losses (EL). However, most real life bankruptcy procedures implement only the proportionality principle. We construct a noncooperative investment game with sequential investment decisions to explore whether the explanation lies in the alternative implications of these principles on investment behavior. Our results are as follows. First EL always induces higher total investment than PRO which in turn induces higher total investment than EA; this is consistent with the findings of Kıbrıs and Kıbrıs (2010) who analyze an investment game with simultaneous investment decisions. Second, we observe that under both EA and EL, changing the order of moves from simultaneous to sequential effects increases total investment, independent of the identity of the first-mover. Finally, we also compare these principles in terms of social welfare induced in equilibrium and have following results. A switch from PRO to EA or EL, may decrease both egalitarian and utilitarian welfare independent of the setting used. Moreover, a transition from a simultaneous case to a sequential case may increase egalitarian welfare independent of the rule used. This transition may also increase utilitarian social welfare under EA but decrease it under EL.