Other policies when there is a rule of no liability

When there is a no liability rule in place, there may be supplementary policy instruments which induce firms to increase their care above xt = 0. This section examines one example of such a policy.

A lump-sum subsidy.

Consider a policy which pays firms to take care. Suppose that the government grants a lump sum cash payment to the firm if it takes the efficient level of care, but not otherwise. Thus, the subsidy is equal to:

where S > wtx*q for any q. The firm's profit function is now:

Since S > wix*q, each firm maximises profits by choosing xt = x*. Each firm's marginal costs are:

But its average costs are:

In other words, the subsidy increases marginal costs but reduces average costs.

The effect of this subsidy on market outcomes is shown in Figure 4.3.4, where the market is initially in a long-run competitive equilibrium with a no liability rule, denoted by point 0. Then the subsidy is introduced. This induces individual firms to choose the efficient level of care. The subsidy therefore increases marginal costs, and the short- run market supply curve also shifts upwards by the cost of care, wix*.

A lump-sum subsidy to provide the efficient level of care

Figure 4.3.4 A lump-sum subsidy to provide the efficient level of care

The intersection of the new market supply curve and the demand curve gives us the new price in the short run. The new short-run equilibrium is at point 1. The economic incidence of the higher costs depends on the elasticity of demand and is shared between producers and consumers.

Since the subsidy paid to firms is designed to exceed the full cost of care, the average costs of each firm fall. Thus, at point 1, after the subsidy is introduced, firms earn positive profits. With free entry into the industry, the number of firms in the market increases. This pushes down the market price, shifting the market short-run supply curve downwards. This continues until the new long-run equilibrium (point 2) is reached, where firms again earn zero profits.

Even though each firm chooses the efficient level of care in the short- and long-run equilibrium, there are too many firms in the industry, the market price is too low, and the total quantity produced is too high. The subsidy is inefficient - and total output is even higher than it is at point 0, under a no liability rule.

Intuitively, the social cost of a firm entering this industry and producing an additional unit is wix* + H(x*). But instead of facing firms with this social cost when they produce their first unit, the subsidy encourages entry. The result 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.

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