Short- and long-run competitive equilibrium under strict liability.

Suppose we are in some long-run equilibrium where there is no liability rule in place. In the short run, suppose the number of firms is fixed at (say) n0. Now introduce a strict liability rule. Forcing the firm to compensate victims acts like a specific tax on production, where firms get to choose the expected size of the tax by choosing their level of care. In the short run, this rule increases marginal and average cost, and we get an upward shift in the short-run supply curve by wix* + H(x*). In the short run the market price rises, but not by the full amount of the costs care plus the expected harm. The extent of the price rise in the short run depends on the elasticity of demand. The legal incidence of the rule of strict liability is that firms pay the costs of care and expected harm, but in the short run the economic incidence is shared between producers and consumers of the good. In the short run the quantity produced by each firm falls, since they choose production to equate their new marginal cost with the higher price. Relative to a situation with no harm, this situation involves negative profits. Total quantity is lower.

In the long run, firms will exit the industry, driving up the market price until profits are driven back to zero. Thus, in addition to producing at a point where price equals marginal cost, firms earn zero profits, so we

also have P* = wx* + H(x*) + C(q). Thus, price equals full average cost.

SL q

But once again, since marginal cost also equals price, which in turn is equal to average cost, we must have marginal cost equal to average cost. This again occurs at the minimum of the average cost curve, which now includes social costs: the cost of care and the expected harm.

The long-run competitive equilibrium is shown in Figure 4.3.1 below. The long-run market supply curve is flat and is equal to the minimum of the new average cost curve. Note that for each firm this minimum occurs

at the same point as it did when the product was not dangerous: the

. . C(q)

quantity q*, which minimises wtxt + H (xt) +—- is the same quantity

that minimises C(q). This happens because under a strict liability rule, q

the marginal and average cost curves shift upward in a parallel fashion. Each firm is forced to pay the cost of care and the expected harm per unit of the good, and this acts like a specific tax as in Chapter 1. Even though firms bear all of the legal incidence of the strict liability rule, consumers will bear all of the economic incidence of this rule in the long run.

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