Extended liability for environmental accidents: what you see is what you get

When a firm may be bankrupted by the liability from an environmental accident, current laws often allow for the extension of liability to third parties with whom the firm contracts, with the aim of inducing full internalization of social costs. We find that, when the firm can take both observable and unobservable care to reduce expected accident damages, extended liability indeed results in full cost internalization, but not in first-best levels of care. We also find that, whereas without extended liability there is excess entry into environmentally hazardous industries, introducing extended liability leads to exit that, while excessive relative to the first best, is second-best optimal given firmsʹ choice of care. Furthermore, we show that direct regulation of observable care, when combined with extended liability, further distorts firmsʹ incentives. However, when used alone, such regulation strictly dominates extended liability.