This section examines the welfare consequences of various liability rules in a competitive market setting when production causes external harm. We consider three rules: no liability, strict liability and a negligence rule.
Consider a no liability rule, where firms do not have to compensate victims. For any q, each firm's profit is equal to:
Firms now have no incentive to take care, so they choose xt = 0. They supply q up to the point where price equals marginal cost, so this means that the quantity supplied satisfies P = C'(q). The market equilibrium is
identical to the one discussed in Chapter 2, when there was no harm. Marginal private consumption benefits equal marginal private costs, but these costs are less than social costs. Hence the competitive equilibrium under a no liability rule is not efficient.
Under a rule of strict liability, firms must compensate those harmed for all losses. Since firms must fully compensate victims, each firm's profit is equal to Pq — q[wtxt + H(xt)] — C(q). Each price-taking profit-maximising firm produces at the point where price is equal to marginal cost, so:
Furthermore, for any q, under a strict liability rule, firms are faced with the full social costs of their actions. Therefore they will minimise the costs of care by equating the marginal benefits of care (the reduction in damages that they must pay consumers) with the marginal costs, so that:
Note that this is the same as the efficiency condition for care - firms take the efficient level of care under strict liability.