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The article characterizes the entry incentives provided by increases in product liability under various forms of competition. It is demonstrated that the entry of small, high-cost firms is likely to occur in imperfectly competitive markets when the average damage increases with industry output. Special cases are considered, including Cournot–Nash oligopoly and dominant firm-competitive fringe.

The impact of product liability rules on market equilibrium is a central question in the economics of law. Indeed, a great deal of debate has focused on the observed structural changes in hazardous product industries that undergo an increased exposure to liability. At the center of this question is the empirical finding that the average scale of firms in hazardous product industries declined and de novo entry of small firms occurred in the 1967–1980 period of rapid changes in liability law. In one significant article, Ringleb & Wiggins (1990) examined a wide range of hazardous industries and found that increases in potential liability are linked to substantial increases in the number of small firms operating in these sectors. Our goal is to provide a simple, yet general, exposition of the market structure implications of increased producer exposure to liability. We characterize entry incentives in a variety of settings for the case where the extent of producer liability is determined by total industry output of a hazardous substance. This case encompasses some important real-life situations. One significant example is the case of liability for hazardous products such as cigarettes or pharmaceuticals (the synthetic estrogen diethylstilbestrol [DES] and the childhood diptheria-pertussis-tetanus [DPT] vaccine being prime examples), where it is difficult, if not impossible, to allocate responsibility for individual injuries among companies. Another good example is the case of environmental health risk, where public health is affected by the total amount of some toxic substance. In such instances, the courts have increasingly turned toward the use of proportional liability rules.1 %The assumption of proportional liability is also related to the burden of traditional regulation. Firms with larger facilities bear proportionally higher costs of complying with environmental and safety regulations than smaller firms. For example, firms with larger facilities face higher potential costs when large sites are more difficult to inspect or when more reports are required to meet regulatory requirements. Pashigian (1984) shows that increased regulation in the early 1970s led to a decrease in the optimal size of manufacturing plants, a finding that closely parallels the results of Ringleb & Wiggins (1990) for increases in liability. In this article, we characterize the marginal effects of an increase in product liability for several indicators of industry structure: output per firm (for various cost types), total industry output, small-firm entry, and incumbent market shares.2 We base our observations on a generalized conjectural variations model with asymmetric costs, endogenous entry, and complete capitalization. To capture a wide range of oligopoly outcomes, including the case of dominant firm(s) with a competitive fringe, the model allows conjectures to differ across firms. For various parameter values of the industry demand and external damage functions, we demonstrate that an increase in producer liability stimulates small-firm entry. In particular, small-firm entry is likely to occur when the average damage function increases in the level of industry output of the hazardous product. The intuition for such an effect is straightforward. If the average damage function associated with an environmental contaminant increases with industry output, a producer liability rule shifts the marginal benefit schedule of each incumbent firm downward but also makes it more inelastic. Increased producer liability may, thus, increase equilibrium price–cost margins and create an incentive for small-firm entry. Our analysis indicates that the entry incentives provided by liability rules are richer and more pervasive than previous analyses suggest. Ringleb & Wiggins (1990) and others hypothesize that the entry of small firms following increased liability exposure is the result of incomplete capitalization or latent risks that allow small firms to cease production before injury emerges. Such divestiture is liability reducing when the firms conducting the risky task have insufficient assets to pay damages and declare bankruptcy when suits are filed or, in the case of latent health risks, exit the industry before injury emerges.3 This idea that small-firm entry occurs through divestiture following increased producer liability is based on the common conception that structural considerations lead industry output to increase with entry (see, e.g., Seade 1980a and Mankiw and Whinston 1986). Much of the force behind the divestiture claim rests on the fact that the observed entry in hazardous product industries is coupled with decreased industry output. If industry output decreases with entry in hazardous sectors, then intuition suggests that structural forces be ruled out as the precursor to entry. This article shows that a decrease in industry output is, in fact, a necessary condition for small-firm entry to occur in response to increased producer exposure to liability. In general, entry can occur either following a parallel outward shift in marginal benefit, or, in the case of an oligopolistic industry, in response to a clockwise pivot in the marginal benefit schedule as firms respond to a relatively more inelastic marginal benefit function by increasing their price–cost margins. In the former case, increased product liability implies industry output declines (and exit occurs), whereas in the latter case industry output declines but entry occurs. Consequently, entry can only occur in response to increased liability exposure when industry output declines. The implication of this finding is that small-firm entry can be explained by more than divestiture incentives or incomplete capitalization alone. The remainder of the article is organized as follows. Section 2 develops the basic liability model and discusses its relationship to other models of oligopoly and to other models commonly used in the liability literature. Section 3 derives the marginal impacts of an increase in producer liability on incumbent output levels and the number of small, high-cost firms. Section 4 highlights the importance of the shape of the damage function for the comparative statics results. Several special cases of the model are considered that emphasize the heretofore unrecognized point that entry incentives depend on the sign of the average damage relationship. Concluding comments are provided in Section 5.

This article has considered the impact of product liability on market equilibrium in a wide variety of industry settings. Our main result is that the entry of high-cost firms is more likely to occur when the marginal benefit schedule is convex and when the change in the unit liability elasticity is large. A large, positive change in the liability elasticity implies that the marginal benefit schedule becomes more price elastic at the equilibrium point, which leads to greater shifting of liability into price. In cases where liability is shifted by more than 100% into price, entry can occur as the marginal profitability of production increases. We also demonstrate that a contraction of total industry output is a necessary condition for small-firm entry to occur following an increase in liability. In an important article, Ringleb & Wiggins (1990) found that an increase in producer exposure to liability frequently precedes the entry of small, high-cost firms and leads to increases in the market share of high-cost firms in hazardous sectors of the economy. Ringleb & Wiggins (1990) hypothesize that such entry results from the desire of large, incumbent firms to shield themselves from liability by divesting risky activities. Our article has demonstrated that incomplete capitalization and divestiture incentives are not the only possible motivations for the entry of high-cost firms to occur in response to increased product liability. The article clarifies the role of the unit liability function in determining entry incentives in industries with environmentally hazardous output. In a wide variety of circumstances, the entry incentive is fundamentally related to the change in the slope of the unit liability function. In particular, increased producer exposure to liability is likely to result in small-firm entry when the slope of the unit liability function increases with the change in liability structure. Under such conditions, increased liability shifts the marginal benefit schedule downward for each incumbent firm but also makes it more price elastic. The imposition of producer liability, thus, may increase industry price–cost margins and lead to the entry of high-cost firms, results that suggest the relationship between liability and market structure is richer than previously recognized. and