Product liability rules in perfectly competitive markets

This section examines the welfare consequences of various product liability rules in a competitive market setting. We consider three rules: strict liability, no liability and a negligence rule. We focus on the long- run, where firms can freely enter and exit the market and where firms can vary all inputs.

Strict liability

Under a rule of strict liability, firms must compensate consumers for all losses. This means that risk-neutral consumers treat the good as if it was perfectly harmless (since they are fully compensated for any harm that occurs), and that producers factor in all expected harm into their cost base. Since consumers regard the good as harmless, the consumer demand curve is:

Note that consumer perceptions of harm do not enter into the demand curve. Since consumers are risk neutral and are fully compensated for all harm under the strict liability rule, their perceptions of the expected harm are irrelevant for demand.

Since firms must fully compensate consumers, each firm's profit is equal to Pq - q[wx + H(x)] - C(q). Each price-taking profit-maximising firm will produce at the point where price equals marginal cost, so:

Furthermore, for any q, under a strict liability rule, firms are faced with the full social costs of their actions. Therefore they will minimise the costs of care by equating the marginal benefits of care (the reduction in damages that they must pay consumers) with the marginal costs, so that:

This is identical to equation (6.3), so xSL = x*. In a long-run competitive equilibrium, firms enter (or exit) the industry until profits are driven zero. For each firm, the average cost is:

What quantity is produced by each firm in a long-run competitive equilibrium? It is the quantity that minimises average cost. But the quantity

that minimises also minimises C(q ) + wx* + H(x*). Therefore, under our assumptions, the quantity that minimises average costs is the same as if the good was not harmful. Therefore qSL = q*. In other words, under a strict liability rule the marginal cost curve and average cost curves are vertical, parallel translations of the original cost curves.

Figure 6.4.1 plots the marginal and average cost curves (MC0, AC0) for a harmless good, as well as the long-run supply curve (LRS0) when the good is harmless. The diagram also plots the same (higher) curves under a strict liability rule when the good is potentially harmful. Notice that irrespective of consumers' estimates of the harm of the good, the demand curve under a strict liability does not shift, since consumers are assumed to be risk neutral and under this legal rule they are fully compensated for any losses.

Competitive equilibrium under strict liability

Figure 6.4.1 Competitive equilibrium under strict liability

In addition to producing at a point where price equals marginal cost,

C(q*)

firms earn zero profits, so we also have PSL

q

Thus, price equals full average cost. 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 the cost of care and the expected harm. The long-run competitive equilibrium is shown in Figure 6.4.1. The long-run market supply curve is flat and is equal to the minimum of the average cost curve.

The strict liability rule produces an efficient outcome. In the long run, each firm produces the same quantity that it did when the good was harmless, but there are fewer firms in the industry. The aggregate market quantity is lower, and consumers of the good bear the entire incidence of the harmfulness of the good. Compared to a harmless good, prices are higher by wx* + H(x*), so the competitive price under strict liability is:

 
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