Product Safety : Liability , R & D and Signaling

* The financial support of NSF grants SES91-12914 and SES92-23087 is gratefully acknowledged. ABSTRACT This paper develops a two-stage model of product design and safety signaling incorporating a parametric liability specification in a monopoly context. In the first stage, the firm engages in research and development in order to determine the safety of its product. We model the research and development process as sequential sampling from a fixed distribution of potential safety levels. Thus, R&D is a stochastic process, partially controlled by investment, which ultimately yields an equilibrium set of acceptable safety levels. Since the outcome of research and development trials is unobservable to consumers, in the second stage of the model the firm must choose its price with the understanding that consumers may attempt to draw inferences about the product's safety from the firm's pricing behavior. Given the price, consumers infer the level of safety and choose the amount of the product to acquire; injuries then lead to losses which are allocated by the particular liability system in place. We vary the liability system's allocation of losses and trace out the implications for the level of R&D investment and the relationship between price and safety. We find that pricing and liability jointly distribute the value and losses associated with the product. When the liability system is firm-oriented, signaling distortions involve high prices to signal safety when the firm's liability is small compared with the cost reduction associated with lower safety, and low prices to signal safety when the liability exceeds the cost reduction. When the liability system is consumer-oriented, risky products require higher prices to compensate for large potential downstream liabilities of the firm. We also find that the average level of product safety under incomplete information is lower than would, on average, obtain under full information. The amount of R&D investment with regards to safety of the product is influenced by the firm's level of liability and the cost of producing the product. More precisely, when the firm's liability is less than the cost reduction, R&D activity may be used to lower product safety. When the firm's liability is greater than the cost reduction, R&D will be used to increase safety, but again, not on average to the level that would obtain under full information. In this latter case, the possibility of less safe products creates an externality for all products in the equilibrium producible set: safer products …