The Search for Deep Pockets: Is "Extended Liability" Expensive Liability?

Abstract

This article examines the effects of extending liability from a producer firm that generates and controls risk to firms who profitably transact with the producer but cannot directly control risk. Examples of extended liability include the liability of retailers for design defects in the products the retailer sells, and the liability of waste shippers for leaks in the landfills that dispose of the shipper's waste. We show that while extending liability forces greater joint cost internalization, it need not improve welfare. The reason is that extended liability can lead to two types of cost-increasing distortions. First, in order to externalize liabilities, the firms to whom liability is extended may reduce capital investment and/or increase output. Second, extended liability can distort the pattern of transactions between riskgenerating firms and those with whom they contract, since deep-pocketed firms have an incentive to avoid transactions with more shallow-pocketed firms. To evaluate the ultimate desirability of extending liability, both of these welfare losses must be balanced against the benefit of improved deterrence.

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