Product Liability versus Reputation

Abstract

Market reputation is often perceived as a cheaper alternative to product liability in the provision of safety incentives. We explore the interaction between legal and reputational sanctions using the idea that inducing safety through reputation requires implementing costly "market sanctioning" mechanisms. We show that law positively affects the functioning of market reputation by reducing its costs. We also show that reputation and product liability are not just substitutes but also complements. We analyze the effects of different legal policies, and namely that negligence reduces reputational costs more intensely than strict liability, and that court errors in determining liability interfere with reputational cost reduction through law. A more general result is that any variant of an ex post liability rule will improve the functioning of market reputation in isolation. We complicate the basic analysis with endogenous prices and observability by consumers of the outcome of court’s decisions. (JEL K13, K23, L51, H24)