The Inefficiency of Contractually-Based Liability with Rational Consumers

The prevailing view in the law and economics literature is that preventing firms and consumers from contracting out of mandatory liability rules is optimal only if consumers are irrational or misperceive the risks of the products they buy. In this paper, I show that even if consumers do correctly judge a product's risk, if they cannot directly observe the safety characteristics of that product, then allowing firms and consumers to choose their own liability rules cannot lead firms to make efficient investments in product safety (unless the efficient level of investment is zero). Because the legal system is costly, consumers always have an incentive to waive liability in exchange for a lower price after safety investments are sunk. If they do so, however, firms will anticipate this, thereby undermining there incentive to invest in safety. Mandatory product liability provides a mechanism for consumers and firms to commit not waive liability. Copyright 2006, Oxford University Press.