Negligence rule

Now consider a negligence rule, where the due standard of care is set at the efficient level. For any q, each firm's profit is now equal to Long-run competitive equilibrium under a strict liability rule

Figure 4.3.1 Long-run competitive equilibrium under a strict liability rule

Firms supply q up to the point where price equals marginal cost, so this means that the quantity supplied satisfies:

Since the due standard is set at the efficient level of care, firms can lower their marginal costs and avoid paying damages to the victim by choosing the efficient level of care here. Therefore, each firm chooses xt = x*, and chooses to produce at the point where marginal cost equals price:

Short- and long-run equilibrium under a negligence rule.

In the short run, the number of firms is again fixed at (say) n0. Consider the same thought experiment as in the previous section. Suppose we are initially in some long-run equilibrium where there is a no liability rule. Now introduce a negligence rule. Each firm's marginal and average costs increase by wix* rather than w;x* + H(x*). This increases marginal and average cost - but not by as much as under the strict liability rule. In the short run we get an upward shift in the short-run supply curve by w;xf. The market price rises, but not by the full amount of the costs of care.

Once again, the extent of the price rise in the short run depends on the elasticity of demand, and once again, the legal incidence of the rule of strict liability is that firms pay the costs of care, but in the short run the economic incidence is again 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. But this reduction is not as large as it is under strict liability. Relative to the original equilibrium, this situation again involves negative profits.

In a long-run competitive equilibrium, firms will exit the industry and the market price will rise 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 = w.x*+ C(q). Once again, since

q

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 only includes the cost of care, but does not include the expected harm created by each unit of the good. Thus, the market price does not adjust to equal full (social) average cost. The long-run competitive equilibrium is shown in Figure 4.3.2 below. The long-run market supply curve is again flat and is equal to the minimum of the average cost curve, where costs now include the cost of care but not the expected harm. Note that this minimum occurs at the same point as it did when the product was not dangerous: the quantity

q that minimises wtx* + C(q) is the same quantity that minimises C(q).

q q

This happens because under a strict liability rule, the marginal and average cost curves shift upwards in a parallel fashion. Each firm pays the efficient cost of care, and this again acts like a specific tax, but the 'tax' is only equal to w{x* < wtx* + H(x*) . Intuitively, the social cost of a firm entering this industry and producing an additional unit is wix*+ H (x*). But under a negligence rule, firms only have to pay wix* to avoid liability. The result in the long run is excessive market entry: even though each individual firm chooses the efficient level of care and the efficient quantity, an inefficiently high amount of the good is produced in the long-run equilibrium, because there are too many firms in the industry and the market price is too low. In a perfectly competitive market, a negligence rule does not produce efficient results.

Long-run competitive equilibrium under a negligence rule

Figure 4.3.2 Long-run competitive equilibrium under a negligence rule

 
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