Abstract: A potentially dangerous product is supplied by a competitive market. The likelihood
of a product-related accident depends on the unobservable precautions taken by
the manufacturer and on the type of the consumer. Contracts include the price to be
paid by the consumer ex ante and stipulated damages to be paid by the manufacturer
ex post in the event of an accident. Although the stipulated damage payments are a
potential solution to the moral hazard problem, firms have a private incentive to reduce
the stipulated damages (and simultaneously lower the up front price) in order to attract
the safer consumers who are less costly to serve. The competitive equilibrium–if an
equilibrium exists at all–features suboptimally low stipulated damages and correspondingly
suboptimal levels of product safety. Imposing tort liability on manufacturers for
uncovered accident losses–and prohibiting private parties from waiving that liability– can improve social welfare.