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An Experimental Investigation of Moral Hazard in Costly Investments

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Abstract

Frequently, parties make sequential decisions regarding investments for which the probability of success or failure is dependent on the amount of total investment. This paper reports a series of experiments involving a costly investment game that is derived from the catalytic finance model of Morris and Shin (Global games: Theory and applications. In Advances in Economics and Econometrics, Proceedings of the Eighth World Congress of the Econometric Society, edited by M. Dewatripont, L. Hansen, and S. Turnovsky. Cambridge, MA: Cambridge University Press, pp. 56–114). The sequential nature of investments is such that the second investment could function as a complement to the initial investment or simply serve as a substitute to it, thereby creating moral hazard. The features of this game are similar to those of the ultimatum game. However, there are several key differences between the games that may account for the high frequency of materially self-interested behavior that we observe, particularly among second movers.

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