Prospect theory and the effects of bankruptcy laws on entrepreneurial aspirations

Abstract

We apply prospect theory to explain how personal and corporate bankruptcy laws affect risk perceptions of entrepreneurs at time of entry and therefore their growth ambitions. Previous theories have reached ambiguous conclusions as to whether countries with more debtor-friendly bankruptcy laws (i.e. laws that are more forgiving towards debtors in bankruptcy proceedings) are likely to have more entrepreneurs, or whether, creditorfriendly regimes have positive effects on new ventures via enhanced incentives for the supply of credit to entrepreneurs. Responding to this ambiguity, we apply prospect theory to propose that entrepreneurs do not attach the same significance to different elements of bankruptcy codes—and to explain which aspects of debtor-friendly bankruptcy laws matter more to entrepreneurs. Based on this, we derive and confirm hypotheses about the impact of aspects of bankruptcy codes on entrepreneurial activity using the Global Entrepreneurship Monitor combined with data on both personal and corporate bankruptcyregulations for 15 developed OECD countries. We use multilevel random coefficient logistic regressions to take account of the hierarchical nature of the data (country and individual levels). Because entrepreneurs and creditors are sensitive to different elements of the codes, there is scope for optimisation of the legal design of bankruptcy law to achieve both an adequate supply of credit and to encourage high-ambition entrepreneurship.