Markets, Torts and Social Inefficiency

Abstract

In this paper we examine the nexus between product markets and the legal system. We examine a model wherein oligopolists produce differentiated products that also have a safety attribute. Consumption of these products may lead to harm (to consumers and/or third parties), lawsuits, and compensation, either via settlement or trial. Firm-level costs reflect both R&D and production activities, as well as liability-related costs. Compensation is incomplete, both because of inefficiencies in the bargaining process and (possibly) because of statutorily-established limits on awards. We compare the market equilibrium safety effort and output levels to what a planner would choose. We consider two planners, one of whom is able to set safety standards, but takes the market equilibrium output as given, and one of whom can control both safety effort and output. We argue that the former type of planner is the better representative of what the tort system might do if faced with deciding upon a safety effort standard. We examine two measures of competitiveness: The number of firms, and the degree of substitutability of the products. Holding substitutability constant, an increase in the number of firms always reduces equilibrium safety effort. On the other hand, holding the number of firms constant, increasing substitutability first decreases, but ultimately increases, the equilibrium safety effort. Non-cooperative firms under-provide safety effort (relative to the restricted social planner's preferred level) when the products are relatively poor substitutes. However, when the products are sufficiently good substitutes, the non-cooperative firms over-provide safety effort. Moreover, the more firms there are in the industry, the less substitutable their products need to be in order for the equilibrium to result in over-provision of safety effort. Under-provision of safety becomes more typical as the rate of third-party exposure increases or as the amount of third-party uncompensated losses increases. Finally, we use the settlement subgame to examine the effects of alternative tort reform policies on the equilibrium provision of safety and welfare. In the presence of third-party victims, welfare can be increased even though changes in such policies may increase expected trial costs.