Taxation, fines, and producer liability rules: efficiency and market structure implications.

• Author: Hamilton, Stephen F.

1. Introduction

   The control of external diseconomies created by worker, consumer, and environmental exposure to hazardous substances is a pervasive problem. In many industries, consumers and workers are routinely exposed to health risks associated with radiation, cigarette smoking, diethylstilbestrol (DES), asbestos, saccharin, dioxin, vinyl chloride, beta-napthylamine, benzidine, coke-oven emissions, and various occupational carcinogens arising from the use of basic materials such as pesticides, petroleum, coal, paraffin, iron ore, nickel, and chromium. Other industries involved with petroleum production, nuclear power generation, metal mining and smelting, pulp milling, and solid waste disposal pose the threat of contamination through accidental "spills" into the environmental medium. The unifying feature of these problems is that the extent of external damages, whether embodied in the probability of product failure or in the likelihood of human and environmental exposure to hazardous substances, is determined jointly by a producer's choice of output and safety provision.

   Two important forms of externality control in hazardous sectors of the economy are producer liability rules and direct regulatory control through the use of output (Pigouvian) taxation and fines on injuries. This paper provides a comparative analysis of the relative efficiency properties of producer liability rules and regulatory policy in both short-run and long-run competitive equilibria. The essential feature of the model is that the provision of product safety in the hazardous sector is endogenized as a choice variable of the firm. The extent or magnitude of external damages can be limited, for example, by removing carcinogens from consumer products, by following re-entry guidelines after the application of pesticides, by requiring safety gear for construction workers, or by implementing better containment measures for solid and liquid waste. Given the conceptual unity of worker, consumer, and environmental safety issues, producer liability rules and regulatory controls are nested in a general model that allows their comparative properties to be examined.(1)

   The theoretical framework, which views producer care as a choice variable of the firm, falls within a family of papers in the liability literature (e.g., Hamada 1976; Shavell 1980; Landes and Posner 1985; Marino 1988). In each of these papers, producer (or strict) liability achieves social optimality in a long-run competitive equilibrium, provided that the extent or likelihood of damage is not correlated across firms (i.e., no externalities exist in the liability functions).(2) The present analysis supports the finding that tort liability achieves a first-best resource allocation in the long run but finds the choice of regulatory controls to be more problematic.

   In an important contribution, two papers by Carlton and Loury (1980, 1986) discuss the limitations of Pigouvian taxes in long-run equilibria. For the case of unavoidable damages, they demonstrate that a Pigouvian tax, which does not affect the privately optimal scale of each competitive firm, is inefficient when the damage function does not depend multiplicatively on the item that is taxed. This finding, though certainly important, is limited by the fact that firms typically exert some control over the extent of external damages through their choice of safety provision. In the following section, the limitations of Pigouvian taxation are revisited in a model that allows competitive firms to invest in product safety measures that reduce the probability of accidental injury to workers, consumers, and the environment. It is shown that Pigouvian taxation fails to achieve a socially optimal outcome in a long-run competitive equilibrium in which both output and safety provision are taxed (subsidized) according to their marginal contributions to social damage. Conversely, an appropriately designed policy involving fines on accidents and subsidies on safety provision does achieve an efficient outcome; however, the optimal policy may involve the taxation, not the subsidization, of product safety.

   This paper also addresses the effect of increased exposure to tort liability on market structure. The existing literature regarding the effects of producer liability on market structure has focused on the issue of solvency (e.g., Ringleb and Wiggins 1990; Boyd and Ingberman 1994; Watts 1998). In particular, there is some evidence that an increase in producer liability may have little effect on product safety when assets can be shielded through divestiture. In a recent paper, Ringleb and Wiggins (1990) examine a wide range of hazardous industries and find that increased exposure to tort liability tends to stimulate de novo entry.(3) Ringleb and Wiggins hypothesize that the entry of firms results through incomplete capitalization and/or through latent risks that allow small firms to cease production before claims are made. Such divestiture is liability reducing when small firms conducting the risky task have insufficient assets to pay damages and declare bankruptcy when suits are filed or, in the case of latent harm, exit the industry before injury emerges. It is shown here that, regardless of firm solvency, entry and loss of incumbent market share can occur purely through market forces following an increase in producer liability exposure. The finding that increased tort liability induces entry in hazardous sectors, therefore, is not sufficient evidence to support the hypothesis that firms respond to greater liability exposure by divesting risky activities.

   The remainder of the paper is structured as follows. In the next section, a model is developed to address the comparative efficiency properties of tort liability and regulatory policy in short-run and long-run competitive equilibria. Section 3 considers the structural implications of increased producer liability exposure in a market setting with neither regulatory controls nor solvency issues, and section 4 provides concluding comments.

2. The Model

   Consider a simple partial equilibrium model with n identical competitive firms. Each firm produces a homogeneous product with inverse demand given by P(Y), where Y = ny is total industry output. Production by each firm in the industry also imposes additional damages to society, g(y), in the event of an accident. The expected damage, D, created by a firm's production decision is given by D = ag(y), where a[Epsilon] [0,1] is the probability in which an accident occurs. In cases in which damages arise through worker exposure to toxic substances or through environmental "spills," a may be interpreted as the probability of product failure, as in Marino (1991). In cases in which external damages arise through health risk, a may be interpreted as an inverse measure of product safety, for example, the level of product carcinogenity or the degree of worker exposure to toxic substances. Throughout, the accident probability is designated quite generally as an inverse measure of product safety. To produce y units of output at safety level a, the representative firm incurs production costs of c(a,y), where dc(a,y)/dy [greater than] 0 and dc(a,y)/da [less than] 0.

   The policy maker's problem is to choose industry output and the number of firms in a partial equilibrium setting so as to maximize social welfare. In this context, social welfare is defined as total consumer surplus net of production costs and external damages in the hazardous sector. In a short-run equilibrium, the number of firms is fixed and the socially optimal a and y can be completely...