Monopoly, Liability and Regulation

Abstract

Our society regulates the quality and safety characteristics of a large number of products destined for consumer use. In many of these cases, our legal system holds the producers of such regulated products liable for harm which is inflicted in the course of consumption. Examples of the joint use of liability and safety regulation include the cases of drugs, foods, pesticides, herbicides, and some aspects of consumer product design. This paper is concerned with cases where it is socially beneficial to regulate safety characteristics of products (or simply cases where we do regulate for whatever reason) and asks whether or not it is in addition socially desirable to impose liability on producers. As an alternative, we consider the rule of no liability and specifically ask whether in a regulated setting it makes economic sense to release producers of liability for harm done. In our analysis, the key determinants in the answer to this question are what we term with respect to the marginal probability of the product causing harm and the degree of ignorance on the part of the consumers of the risky product. The economic environment is that of a regulated monopoly producer of a risky product (e.g., the producer of a patented drug). While the regulator and the firm correctly perceive expected damages associated with the product, the consumer may underestimate risk. The regulatory authority controls the of the product but does not regulate the level of the firm's output. Both care level and output level affect the probability of the product harming a typical consumer. In addition, the firm's output level affects the marginal probability of the product causing harm with respect to output, and we term this phenomenon a scale effect. The provision for scale effects is an extension of previous work on products liability, [1; 2; 3] and [5; 6; 7; 8; 9; 10; 11], which assumes that the marginal probability of harm is a constant function of output. Scale effects can take the form of a locally rising or falling marginal probability of harm with respect to output. The former case corresponds to a product which does cumulative damage as more units are consumed. The latter case corresponds to a product to which a tolerance can be developed. Our principle findings are divided into two cases depending on whether or not the consumer misperceives expected damages. For the case in which consumers correctly perceive expected damages from the product, the desirability of strict liability in combination with regulation versus regulation with release of liability depends on the direction of the consumption scale effects. For the case in which the consumer underestimates the expected damages from the risky product, the