Products Liability, Signaling and Disclosure

We examine the behavior of a firm that produces a product with a privatelyobserved safety attribute. Costly disclosure and price-signaling of safety are alternative firm strategies. The liability system and production cost determine the firm’s full marginal cost. When the firm’s full marginal cost is increasing (decreasing) in safety, a firm with a safer product will distort its price upward (downward) and will sometimes inefficiently choose to signal rather than disclose (to disclose rather than signal). We also allow for a small fraction of naively optimistic (pessimistic) consumers; this leads to less price distortion and decreased (increased) incentives to disclose. (JEL: K 13, L 15, D 82) In this paper we examine the behavior of a firm that produces a product with a safety attribute. We assume that the firm knows whether its product is of high safety or low safety (its “type”), where a safer product is one with a lower probability of causing harm. Consumers of the product cannot observe directly the product’s safety, but they can learn safety through one of two routes. 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. That is, consumers may learn the product’s safety through disclosure or through signaling. 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; this dependence of marginal cost on liability in turn affects the price and the output level for the firm, thereby influencing welfare. In particular, 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 (the composition of marginal cost and its relationship to liability law will be discussed in detail below). We show that