A strict liability rule

Under strict liability, the firm faces a tax equal to the expected marginal costs of its actions. This means that for any x the firm's marginal costs are:

For any value of v, the firm will produce at Q , which is the point where actual marginal benefits equal its marginal costs under the liability rule. Thus for any v, Q is defined by

So for any realisation of v, we have:

That is, strict liability is efficient here, and there is no deadweight loss. The reason is that there is no uncertainty over marginal costs, so the strict liability rule (which forces the firm to pay expected costs) also forces the firm to pay actual costs. This induces the firm to completely internalise the external costs of its actions, and it behaves efficiently.

This result - that a strict liability rule has a lower expected deadweight loss than both quantity and tax regulation - is more general than this example would suggest. Indeed, White and Wittman (1983) show that even if the regulator is uncertain about the position of both the marginal social cost and marginal social benefit curves, a strict liability rule always dominates the other two instruments, irrespective of the slope of these curves and irrespective of the extent of the regulator's ignorance about the position of the marginal benefit and cost curves (that is, irrespective of a2v). The intuition behind this result is straightforward: the strict liability rule acts like a non-linear tax and is more flexible than the other two regulatory mechanisms. When marginal benefits turn out to be high, the strict liability still contains sufficient incentives for the firm to increase

The deadweight loss of a strict liability rule under incomplete information

Figure 4.6.6 The deadweight loss of a strict liability rule under incomplete information: Social marginal benefits turn out to be Less than expected

production, which is desirable from an efficiency point of view. Under quantity regulation, increasing production is not allowed, even if it is efficient. On the other hand, under a tax the firm would increase production when marginal benefits are high, but would do so by too much.

If marginal costs turn out to be high, then under strict liability the firm will not reduce its production. But neither will it do so under quantity regulation. And under a tax, the firm reduces production by too much. So again, if the regulator is uncertain about marginal costs, implementing a strict liability rule turns out to be better, on average, than the other two instruments.

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