The Effect of Liability-Sharing Rules in Delegating Hazardous Activities

This paper examines the effects of liability sharing rules on social welfare and risk reduction when one firm (the principal) delegates indivisible hazardous activities to one of the potential firms (the agents). The problem is posed as providing incentives from the principal to the agents, in the presence of adverse selection and moral hazard through the contract, in order to reduce the level of accident probability under a liability rule in force. The principal wants to delegate the activities to an agent that is a good risk, while the agents compete with one another for winning the contract. Assuming that the principal has enough asset not to face the possibility of bankruptcy under any liability rule in force, we show that (i) when the agents are free from the potential of bankruptcy, strict liability of the principal achieves the highest level of social welfare, and (ii) under the potential of the agent's bankruptcy, a liability sharing rule that achieves the highest level of social welfare depends on the winning agents' asset levels and the costs of risk reduction. Regardless of the potential of bankruptcy, risk minimization results in social welfare maximization