A negligence rule

Now suppose that firms in the industry face a negligence rule. Suppose that the due standard of care is set at the efficient level x*. If firms meet the due standard of care, then consumers will bear all of the costs of any harm from consumption of the good. This will affect their willingness to pay for the good. On the other hand, if firms do not meet the due standard of care, then firms will be liable for any harm - and, once again, this will affect consumer demand. Thus, the consumer demand curve under a negligence rule is:

Thus, producer profits are:

There are three cases to consider, depending on the direction of consumer misperceptions. The outcome depends on the function wx + 1H(x) for different values of l. This function is shown in Figure 6.4.3.

Equilibrium under a negligence rule

Figure 6.4.3 Equilibrium under a negligence rule

6.4.1.3.1 No consumer misperceptions (l = 1). In this case, from equation (6.7) each firm's profit is:

irrespective of the level of care. For any quantity, each firm maximises its profits by choosing x = x*. Each firm therefore avoids liability and has costs of qwx* + C(q). Consumer demand is:

This is identical to the outcome under a no liability rule when l = 1. The market price again is equal to each firm's marginal cost, so that:

and again we have Q NR = Q SL = Q NL = Q*.

This result - the irrelevance of the legal rule for efficiency - has some interesting implications for policy analysis. For example, consider the following policy intervention. Suppose that the legal rule is a no liability rule, and suppose that consumers correctly perceive risk. Suppose that the government is considering placing a per unit tax of t on purchases of the dangerous good. Assuming that consumers correctly perceive the risks involved in consuming the dangerous good, what would be the welfare effects of this tax?

In the above model, a tax on the good drives a wedge between consumer marginal willingness to pay and production costs. But under a no liability rule, consumers already have a reduced their marginal willingness to pay by H(x*), since under a no liability rule they must bear the costs of any harm that the good causes. Since consumers already perceive the risks correctly and since under a no liability rule firms already provide the efficient level of care, an additional tax creates a deadweight loss, just as it does when the good is not dangerous. Once a legal rule is in place and prices can adjust to fully reflect any damage that the good may cause, there is no role for further interventions.

A possible case for intervention may arise if firms have some market power, or if consumers do not correctly perceive risks. However, a tax may not be the most appropriate intervention in these instances. Instead, more appropriate policies might involve lowering barriers to entry, or simply informing consumers of the true nature of the product's risks.

6.4.1.3.2 Consumers underestimate expected harm (l < 1). In this case, each firm's profit is as in equation (6.7). For any quantity, each firm maximises its profits by choosing x = x*. Each firm therefore avoids liability and has costs of qwx* + C(q). In a long-run equilibrium, average costs are again minimised at q*. Consumer demand is:

Since l < 1, the consumer demand curve is to the right of the demand curve for which l = 1. In other words, because consumers underperceive risk, they demand too much of the good relative to the harm that it creates. Therefore, the demand curve meets the long-run supply curve at the point where:

This implies that nNR > n*. When consumers underestimate the expected harm of the product, there will be too many firms in the industry, and consumers consume too many units of the good. Welfare is lower than in the case where we have a negligence rule and l = 1, or where there is a strict liability rule and l < 1.

6.4.1.3.3 Consumers overestimate expected harm (l > 1). In this case, each firm's profit is as in equation (6.7). Now, however, firms have very different incentives from the case where l < 1. If firms choose to meet the due standard of care, consumers will bear all of the losses, and they will reduce demand by an inefficiently high amount 1H(x), since they overperceive risk. But if firms do not meet the due standard of care, they will be found negligent and this will only cost them H(x) < 1H(x). Therefore, each firm is better off not meeting the due standard of care and being found negligent.

Equilibrium under a negligence rule when consumers underestimate harm

Figure 6.4.4 Equilibrium under a negligence rule when consumers underestimate harm

Equilibrium under a negligence rule when consumers overestimate harm

Figure 6.4.5 Equilibrium under a negligence rule when consumers overestimate harm

The profit-maximising choice of x is therefore to provide a level of care that is just slightly below x*. Let this level be x°°. By providing this level of care, each firm incurs liability for consumer harm and has costs of qwx°° + C(q) + qH(x°°). The consumer demand curve is: Equilibrium under a second-best negligence rule when consumers overestimate harm

Figure 6.4.6 Equilibrium under a second-best negligence rule when consumers overestimate harm

This is almost identical to the outcome under strict liability, apart from the fact that the level of care x°° is slightly less than the efficient level x*.

There are alternative second-best negligence rules which would induce firms to choose x = x* when l > 1.

As Figure 6.4.6 makes clear, if the due standard is set slightly higher than x*, then profits will be:

and firms can minimise costs by choosing x* (and will again be found negligent). This outcome is efficient, since consumers' misperceptions will not enter the demand curve (they will be compensated for losses) and firms will provide the efficient level of care.

 
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