Subaquatic (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). 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?