Loss Sharing in Partnerships

Abstract

I use an experiment to analyze individuals’ choices for two well-known allocation rules proposed by the theoretical literature while sharing losses (bankruptcy situation): Equal Losses Rule (EL) and Proportional Rule (PRO). For the experiment, I use an investment game where individuals choose how much to contribute to a group project. The contribution of two individuals determines the value of the project. While this value rises with some probability (success rate), it shrinks (bankruptcy) with the remaining probability. In the case of success, investors obtain an interest that is proportional to their initial investment, and in the case of bankruptcy, they use either EL or PRO to share the shrunk value. In this game, given the symmetry for agents’ risk aversion, a risk-neutral agent obtains the same expected payoff under both bankruptcy rules in equilibrium. However, depending on the individual’s expectation about group’s average investment level compared to her own investment level, an individual may prefer one rule to another. I first test how agents’ rule choices differ depending on the success rate, their expected payoffs, which are calculated by using their beliefs about group’s average investment, as well as some personal characteristics, like gender, and risk aversion. I observe that subjects expect their group members to invest as much as they do under both rules, and they are indifferent between the rules. I also observe that both rules induce similar investment levels, which are independent of subjects’ risk aversion.