Products Liability, Signaling and Disclosure

Abstract

In this paper we examine the behavior of a firm that produces a product with a privately-observed safety attribute; that is, consumers cannot observe directly the product's safety. The firm may, at a cost, disclose its safety prior to sale; alternatively, if a firm does not disclose its safety then consumers can attempt to infer its safety from the price charged. The liability system is important because it is a determinant of the firm's full marginal cost, which consists of both manufacturing cost and liability cost. If the firm does not bear substantial liability for a consumer's harm, then the firm's marginal cost consists mainly of manufacturing cost, which is presumably higher for safer products. On the other hand, if the firm does bear substantial liability for a consumer's harm, then the firm's marginal cost consists of both manufacturing cost and liability cost. In this case, it is quite possible for a firm producing a safer product to have lower full marginal cost. We characterize the firm's equilibrium disclosure and pricing behavior, and compare that behavior and the associated welfare to what would occur under a regime of mandatory disclosure. We derive a range of disclosure costs that would induce a high-safety firm to choose disclosure over signaling. When the firm's full marginal cost is increasing (decreasing) in safety, a firm with a high-safety product will sometimes inefficiently choose to signal rather than disclose (disclose rather than to signal). Furthermore, we find that whether ex ante information regulation (in the form of mandatory disclosure) or reliance on ex post liability that induces information revelation is the better policy also depends upon whether the firm faces substantial liability for a consumer's harm. Finally, we find that a small fraction of naively optimistic consumers (who always buy as if the product were of high safety) leads to higher profits for both less-safe and safer products, and a reduced incentive for voluntary disclosure.

Keywords: products liability, disclosure, signaling, safety, quality

JEL Classification: K13, L15, D82