The effect of liability-sharing rules in delegating hazardous activities

Abstract

This paper examines the effects of liability-sharing rules on social welfare and risk reduction when one firm (the principal) delegates indivisible hazardous activities to one of the potential firms (the agents). The problem is posed as providing incentives from the principal to the agents, through the contract, to reduce the level of accident probability under a liability rule in force. Our main findings are twofold: (1) when the agents are free from the potential of bankruptcy, strict liability of the principal achieves the highest level of social welfare, and (2) under the potential of the agent’s bankruptcy, a liability-sharing rule that achieves the highest level of social welfare depends on the agents’ asset levels and the costs of risk reduction. Regardless of the potential of bankruptcy, risk minimization results in social welfare maximization.