Everybody Out of the Pool: Products Liability, Punitive Damages, and Competition
| DOI | 10.1093/oxfordjournals.jleo.a023390 |
| Pages | 410-432 |
| Date | 01 October 1997 |
| Year | 1997 |
| Published By | Oxford University Press |
410 JLEO.V13N2
Everybody Out of the Pool: Products Liability,
Punitive Damages, and Competition
Andrew
F.
Daughety
Vanderbilt University
Jennifer
F.
Reinganum
Vanderbilt University
We examine how punitive damages and competitive forces generate equilibria
which reveal the safety of a product. We model the monopoly (duopoly) provision
of a product whose safety is unobservable to consumers prior to purchase, but is
known by the firm(s) and can be signaled via the product's price and safety claims.
Consumers' likelihood of purchase is based on the price and claim combination(s)
they
observe,
thereby reducing the incentive for mimicry of the safer product by the
less safe one. Nevertheless, absent punitive damages, there is a broad portion
of the parameter space wherein no revealing equilibria exist. We characterize
the minimal punitive damages necessary to ensure revelation; moreover, we find
that competition reduces the minimal level of punitive damages. Competition and
punitive damages are complementary in that they jointly make consumer choice
more effective by creating conditions under which revealing equilibria can exist.
When a jury or judge awards punitive damages in a products liability action,
what economic purposes are being furthered and how do such legal remedies
conform or conflict with market-based incentives for firm behavior? By their
very name, punitive damages are concerned with punishment, which means
that they may have retributive or deterrence attributes (or both). While legal
scholars have laid out a number of purposes for such awards, the very existence
of punitive damages has been a source of intense current and historical debate.
Comedians, candidates for president, businessmen, academics, and people in
the street all seem to hold views on this seemingly technical and somewhat
arcane issue. Arguments about the level, usefulness, and legitimacy of punitive
damages range from references to "wilful, wanton and outrageous behavior"
on the part of firms, to analogies involving "winning the lottery" for plaintiffs,
The financial support of NSF grants SBR-9223087 and SBR-9596193 is gratefully acknowl-
edged. We also thank Michael D. Green, Preston McAfee, Alan Schwartz, Joel Sobel, two anony-
mous referees, and participants in workshops at Duke University, Georgetown University, Uni-
versity of Illinois-Chicago, University of Iowa, University of Michigan, University of Virginia,
Vanderbilt University, and Virginia Polytechnic Institute and State University.
© 1997 by Oxford University Press. All rights reserved. 8756-6222/97/$5.00
Product; UabBty, Pmitlve Damages, and Competition 411
to claims that such awards are competitively disadvantageous for U.S. firms.
Some states have taken a position in this trade, requiring successful plaintiffs
to share a large portion of any punitive damages they win.
In this article we model a product market wherein the safety of the product
is known to the firms but is not observable by the consumer prior to purchase.
Safety is important because some fraction of the consumers will be hurt through
the use of the product and will suffer losses for which the firms will be liable in
tort.1 The model is sequential in that firms quote prices and make safety claims
and then consumers draw an inference about safety before buying the product.
As is now standard, such incomplete information models give rise to various
types of
equilibria.
In revealing equilibria, consumers are able to properly infer
the true safety level of the product (safety is revealed by the price charged and
the safety claim made).2 In pooling equilibria, this is not possible: consumers
have no more guidance from using the price and safety claims than the initial
distribution over possible levels of safety.3 Using a simple model we find that
for a large range of potential levels of safety, revealing equilibria need not exist
if firms' liabilities are limited to partially compensating consumers for their
losses.4 In other words, even though consumers are acting in their own best
interests, under these circumstances they are unable to provide sufficient incen-
tives to induce the firms producing the products to reveal their true safety level.
Clearly, enormous punitive damages for misrepresentation would (in theory)
lead to revelation. Since these penalties would never be applied in a revealing
equilibrium, it would appear that the use of legal incentives is "free" and hence
should be used to the exclusion of other incentives such as those provided
by the market. However, in reality large penalties may not be credible and
legal incentives are not free. First, as Andreoni (1991) has shown, there is
both an empirical and theoretical basis for expecting very large penalties to
suppress conviction rates in criminal cases, and perhaps to actually reduce
1.
In Daughety and Reinganum (1995b) we discuss, in detail, the difference between liability in
tort and the use of a warranty or contract. In particular, attempts to restrict liability via warranty
disclaimers are not, in general, effective. Firms could offer coverage greater than normally specified
by tort law, though this too would be subject to costly litigation to establish that the product actually
caused the harm. Thus, we argued that only simple warranty contracts based on readily identifiable
events are likely to be offered; real warranties are generally limited to repair, replacement, or
refund. In this article we continue to focus on products liability law as an exogenous influence on
firm decision making [see Schwartz (1988, 1992) for a contracting approach to products liability].
2.
Other price-quality signaling models include Bagwell and Riordan (1991), Daughety and
Reinganum (1995b), Lutz (1989), Milgrom and Roberts (1986), and Shieh (1993). All of these
models generate revealing equilibria, although Milgrom and Roberts and Lutz show that price
alone need not be sufficient to signal quality. Milgrom and Roberts use advertising and Lutz uses
warranty coverage as an additional signaling instrument. In our model we will allow firms to
make safety claims or remain silent. We find that, in equilibrium, such claims provide no extra
information beyond that provided by the price.
3.
Mixed outcomes (semipooling equilibria) may also exist.
4.
In the next section we will provide a variety of economic and legal considerations that should
lead rational plaintiffs to anticipate expected compensation to be strictly less than actual damage
incurred.
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