Markets for Potentially Harmful Goods - The Economics of Product Liability Rules


In the previous chapter we examined situations where the parties undertaking care and incurring harm were 'economic strangers' in the following important sense: there was no existing economic relationship between the parties when they chose their levels of care, or when accidents occurred.

But in a market economy this is by no means the most common situation in which accidental harm occurs. In many situations, the injurer and the victim have engaged in one or more economic transactions before harm occurs. Many such situations are governed by product liability rules. Specifically, product liability laws determine the allocation of damages in situations where firms sell defective or potentially dangerous products to consumers (or downstream producers) in exchange for a monetary payment or a price, and where either firms or consumers (or both) can take care to alter the probability of an accident occurring.

There is a critical difference between this situation and the class of situations examined in the previous chapter: in the situations examined in this chapter, the parties voluntarily enter into an economic transaction before the accidental harm occurs. This means that the expected costs of harm and levels of care can potentially be anticipated and incorporated into the original terms of exchange. Further, expected harm will potentially affect both the demand and supply side of the market as producer costs and consumer willingness to pay may both be affected. Since market prices may adjust in response to consumers' marginal willingness to pay and producers' marginal opportunity

costs - both of which will in general depend on the costs of care and allocation of damages - the incorporation of harm and the costs of care into market prices and quantities may occur even in the absence of formal bargaining between the parties. This means that there are certain situations in which the legal rule may again be irrelevant for both production and efficiency. However, in contrast to the Coase Theorem this irrelevance result holds even in the absence of direct bargaining between the parties.

It turns out that in these situations, under certain assumptions, legal rules are again irrelevant for market efficiency, even though producers and consumers interact anonymously on markets and no direct bargaining takes place. One of the main reasons for this irrelevance result is that competition and the desire to exploit gains from trade provide powerful incentives for producers and consumers to do certain things, even when the law does not compel them to do so. This is a very strong but very important result, and like the Coase Theorem it holds only under some circumstances. The interesting issue is analysing exactly which situations it holds and does not hold, and the implications that this has for the design of legal rules and economic policy more generally.

This chapter is structured as follows. Section 6.2 characterises the conditions for economic efficiency when firms produce goods that can potentially harm the individuals who purchase those goods. Section 6.3 focuses on the key issue of consumer perceptions of harm, and presents a simple framework for modelling the effects of consumer misperceptions. Section 6.4 puts these two pieces of the puzzle together and studies the efficiency properties of legal rules in competitive markets for goods that are potentially harmful to consumers. Section 6.5 extends this analysis to imperfectly competitive market settings. Section 6.6 studies a particular application: employment law and the economics of workplace safety regulations.

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