solution

SubAquatics (SA) sells scuba diving equipment. Its clients typically read specialist

journals and are well informed about the price, reliability, and safety of

SA and competitors’ products. SA has estimated that, of 100,000 units sold

each year at a price of $100 each, there are 4>(1 – s) fatal accidents due to

defective equipment. The value s is the amount spent by SA on safety in millions

of dollars. a. Assuming that SA is fully liable for such accidents and that the average

settlement of each fatal accident is $1 million, how much should SA

spend on safety? Now assume that SA can escape this liability by selling its products

at a lower price under a contract that allocates all responsibility for

accidents to the purchaser (assume that courts enforce such contracts).

If SA spends s (expressed in millions of dollars) on safety, the expected

cost of accidents to any consumer is [4>(1 – s)]($1m>100,000) =

$40>(1 + s). Note that consumers are willing to pay $100 when all

liability is assumed by SA (assuming consumers are risk-neutral).

b. How much would consumers be willing to pay when they bear the cost of

accidents? c. How much would SA spend on safety? d. Assuming that customers cannot observe the level of safety and there is no liability law, how much would SA spend on safety and how much

would customers pay for the product?