AN EXPERIMENTAL ANALYSIS Benjamin Kelly A

SUNK COST ACCOUNTING AND ENTRAPMENT IN CORPORATE ACQUISITIONS AND FINANCIAL MARKETS : AN EXPERIMENTAL ANALYSIS Benjamin Kelly A Thesis Submitted for the Degree of PhD at the University of St. Andrews 2008 Full metadata for this item is available in the St Andrews Digital Research Repository at: https://research-repository.st-andrews.ac.uk/ Please use this identifier to cite or link to this item: http://hdl.handle.net/10023/427 This item is protected by original copyright This item is licensed under a Creative Commons License Sunk Cost Accounting and Entrapment in Corporate Acquisitions and Financial Markets: An Experimental Analysis Benjamin Kelly University of St Andrews, School of Economics and Finance For the Degree of Doctor of Philosophy Date of Submission: 12th December 2006 I, Benjamin Kelly hereby certify that this thesis, which is approximately 72,000 words in length, has been written by me, that it is the record of work carried out by me and that it has not been submitted in any previous application for a higher degree. date 10/12/07 signature of candidate ……… I was admitted as a research student in October 2003 and as a candidate for the degree of Doctor of Philosophy in October 2003 the higher study for which this is a record was carried out in the University of St Andrews between 2003 and 2006 date 10/12/07 signature of candidate ……… I hereby certify that the candidate has fulfilled the conditions of the Resolution and Regulations appropriate for the degree of Doctor of Philosophy in the University of St Andrews and that the candidate is qualified to submit this thesis in application for that degree. date 10/12/07 signature of supervisor ……… In submitting this thesis to the University of St Andrews I understand that I am giving permission for it to be made available for use in accordance with the regulations of the University Library for the time being in force, subject to any copyright vested in the work not being affected thereby. I also understand that the title and abstract will be published, and that a copy of the work may be made and supplied to any bona fide library or research worker, that my thesis will be electronically accessible for personal or research use, and that the library has the right to migrate my thesis into new electronic forms as required to ensure continued access to the thesis. I have obtained any third-party copyright permissions that may be required in order to allow such access and migration. date 10/12/07 signature of candidate …… Acknowledgements Without doubt my PhD studies have been the most instructive and exciting years of my academic endeavour. As in life there are ups and downs and times of frustration but overcoming these hurdles has given me enormous satisfaction. Along the way I have met some truly wonderful people, too numerous to mention but there are certain individuals I would like to thank. I would firstly like to thank Mr Shane Bonetti for his supervision and his constant encouragement and support throughout this endeavour. I feel I have a learnt a huge amount from Shane and not just from an academic perspective. Over the four years he has become a good friend and have appreciated his advice on many topics. He has devoted many hours to the progression of this dissertation and it has been a real pleasure to have him supervise my studies. I would also like to thank him for his highly entertaining and informative lectures over the years. I would also like to thank the members of the Economics department in St Andrews for their analytical advice and encouragement throughout the years. Especially Professor Gavin Reid who has demonstrated great interest in my work and has always made himself available on whatever issue I wish to confront him with. I would like to give special thanks to firstly John MacLeod for his enthusiasm and comments towards this research which I will be forever grateful for and secondly, Christopher McGhee for his IT assistance and tutorage which expediated my write-up process significantly. Naturally, I would like to thank the secretaries of the Economics department: Eliana, Caroline and Angela for all their hospitality and assistance over the years. I would also like to thank the individuals with whom I have shared an office. They are all super people and have made my stay in the department highly enjoyable. I would also like to thank all my friends whom I have shared a flat with in St Andrews over the four years. They have made my postgraduate years my most enjoyable in this town and for that reason would like to fully acknowledge how grateful I am for their friendship. They are (in chronological order): Amir Afshar, Suzanne Laing, David Reid, Josh Jeffrey, Catriona Kneelands Sarah Lynch, David Williams, John Williams, James Chippindale, David Walker, Christopher Burdon, Sarah Dwyer, Holly Fowden, Sarah Rogers, Rebecca Ormisher, Alana Fraser, David Fearnley, Oliver Horrowitz, and Alistair Knight. I would like to thank my Godfather Mr Nigel Strudwick for his financial support and encouragement throughout my studies. It is very much appreciated and hope he enjoys the completed dissertation. I would also like to take this opportunity to thank Stanford Thain for his continued interest in my studies and armouring me with the motivation and belief to combine my academic interests with private sector work during many long days this summer. My parents deserve a special mention for allowing the possibility to pursue my studies beyond undergraduate level. I don’t think either of them expected my university years to be so extensive but they have never offered me anything but total support in whatever course of action I have taken with my education and I am extremely grateful. Table of Contents Tables VII Figures IX Symbols X Abstract XII Chapter 1: Introduction 1 1.1 Introduction 1 1.2 Evidence of the Sunk Cost Effect 3 1.2.1 The Taurus Project 4 1.2.2 The Scottish Parliament 5 1.2.3 Enron 6 1.2.4 Barings Bank 7 1.3 What Drives the Sunk Cost Effect? 10 1.3.1 Project Determinants 10 1.3.2 Psychological Determinants 11 1.3.3 Social Determinants 12 1.3.4 Organisational Determinants 13 1.4 Sunk Costs in Financial Markets 13 1.5 Justification of Research Topic 14 1.5.1 Identification of Problem 14 1.5.2 Research Questions 15 1.5.3 Proposed Solution 16 1.6 Overview of Results 16 1.6.1 Experiment I: Sunk Costs in a Mergers and Acquisition Context 16 1.6.2 Experiment II: Sunk Costs in a First-price, Sealed-bid Auction 17 1.6.3 Experiment III: Sunk Costs in an Experimental Equity Market 17 1.7 Overview of Dissertation 18 I Chapter 2: Theoretical Analysis and Literature Survey 21 2.1 Introduction 21 2.2 Mechanisms of Sunk Cost Accounting 23 2.2.1 Self-Justification Theory 23 2.2.2 Prospect Theory 28 2.2.3 Regret Theory 32 2.3 Literature Survey-Methodology 35 2.3.1 Psychological Factors Affecting Sunk Cost Accounting 36 2.3.1.1 Effects of Internal Justification “Accepting Incurred Losses” 37 2.3.1.2 Psychological Effects of Framing 40 2.3.2 Effects of External Justification: A Social Factor 42 2.3.2.1 Cultural Variance 44 2.3.3 Project Determinants 47 2.4 The Reverse Sunk Cost Effect 53 2.5 Direction of Dissertation 55 2.6 Conclusion 56 Chapter 3: Methodological Issues 58 3.1 Introduction 58 3.2 Development of Experimental Economics 60 3.2.1 Experiments on Markets 60 3.2.2 Public Goods Experiments 61 3.2.2.1 The Generic Public Goods Experiment 62 3.2.3 The Experiments on Individual Learning Processes 64 3.2.4 Experiments on Game Theory 67 3.2.5 Ultimatum Bargaining 68 3.3 Problems with Experiments 71 3.3.1 Theory is Logically Correct 72 3.3.2 Theory is Normative 72 3.3.3 Laboratories are Unable to Replicate the “Real World” 74 3.3.3.1 Financial Incentives 74 3.3.3.2 Learning 76 3.3.3.3 Deception 77 II 3.3.4 Subject Sophistication 80 3.4 What has been Learned? 82 3.5 The Role of Risk in Experimental Decision Making 84 3.6 Propensity to Risk 85 3.7 A Taxonomy of Risk 83 3.7.1 Expected Utility Theory 89 3.7.2 Loss Aversion Theory 91 3.8 Evaluating Risk 92 3.8.1 Risk Aversion and Common Ratio Tests of Expected Utility Theory 93 3.8.2 Preferred Reversal Choice Tasks 94 3.8.3 Multiple Price Listing 97 3.9 Experimental Findings 100 3.9.1 Experimental Elicitation with Monetary Incentives 100 3.9.2 Instantaneous Decision Making Models 103 3.10 Conclusion and Links to Experimental Design 106 Chapter 4: Impact of Sunk Costs on Corporate Acquisition Strategies 109 4.1 Introduction 109 4.2 The St Andrews Bargaining Championships 112 4.3 Experiment I: Multi-issue Negotiations in Mergers and Acquisitions 113 4.3.1 The Merger and Acquisition Environment 113 4.3.2 Experimental Design 115 4.3.2.1 Attitudes to Risk and the Sunk Cost (Section 1) 117 4.3.2.2 Break Even versus Loss Condition (Section 1) 118 4.3.2.3 Multi-issue Negotiations (Section 2) 119 4.3.3 Experimental Procedure 121 4.3.4 Competing Hypotheses 122 4.3.4.1 The Self-Justification Hypothesis 122 4.3.4.2 Escalation of Commitment 124 4.3.4.3 Expected-Utility Theory 125 4.3.4.4 Prior Outcomes Influencing Risky Choice 127 III 4.3.4.5 Gender Differences 129 4.3.5 Results 131 4.3.5.1 Probit Model 139 4.3.6 Discussion 140 4.3.6.1 Alternative Explanations 142 4.3.6.2 Challenges 143 4.3.6.3 Relation to Pre-Existing Evidence 144 4.4 Experiment II: First-Price, Sealed-Bid Auction 146 4.4.1 Experimental Design 146 4.4.1.1 Attitudes to Risk 148 4.4.1.2 Information versus no Information Condition 148 4.4.1.3 The Sealed-Bid, First-Price Auction 148 4.4.2 Experimental Procedure 149 4.5 Competing Hypotheses 150 4.5.1 Fundamental Auction

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