The Optimal Level of Corporate Liability Given the Limited Ability of Corporations to Penalize Their Employees

A central point of the economic analysis of corporate liability for harm done to strangers (parties other than employees or customers of a corporation) is that the level of liability should generally equal the magnitude of harm. The rationale is 2-fold. If liable firms must pay damages 1 equal to harm, then, first, firms will in principle be led to take appropriate care to prevent harm; and, second, product prices will tend to reflect the full social cost of production, inducing consumers to make socially correct purchase decisions. Somewhat surprisingly, however, this familiar conclusion about optimal damages does not necessarily hold when it is recognized that the ability of corporations to impose financial penalties on employees for causing harm is limitedZ; the major sanction suffered by a misbehaving employee is usually, at most, dismissal from his job. ~ If employees have less at stake than the harm they might cause, their motive to prevent harm may be inadequate from a firm's perspective. Firms can partially remedy this problem by paying employees an above-market wage, because that will raise employees' desire to keep their jobs and thus to prevent accidents. 4 But, as will be discussed, a firm's