Liability, Disclaimers, and Adverse Selection By Bryan Caplan

Suppose the law says that parking garages are liable for whatever damages occur on the premises. However, there’s a big loophole: Garages can disclaim liability by posting a big “ENTER AT YOUR OWN RISK” sign. What happens?

Non-economists usually conclude that every parking garage will post the sign to save money. But if you remember the economics of adverse selection, this is a puzzling conclusion. After all, which garages will be most eager to disclaim? The garages that do a terrible job of protecting their customers’ property. So what should customers conclude about the first garage that avails itself of its right to disclaim? That the firm is a “lemon” so they should park their cars elsewhere. If firms anticipate this inference, even high-risk garages have a clear incentive not to disclaim.

In the real world, of course, we see firms disclaiming liability all the time. Why on earth would they do so despite adverse selection?

One possibility is that customers systematically underestimate the risk of damage, but firms don’t. This is surely true in some cases, but it contradicts a vast literature on the psychology of risk showing that people often overestimate risks.

The better explanation is that real-world liability systems are incredibly inefficient. Suppose the typical lawsuit costs the defendant $100,000 but only enriches the plaintiff by $10,000. With a .1% accident risk, a firm’s expected liability is $100, but a customer’s expected damages are only $10. A firm that disclaimed liability and cut the price of parking by $30 would make customers $20 richer and itself $70 richer.

What about the adverse selection problem? The more inefficient the legal system, the easier adverse selection is to solve. Suppose that in the preceding example, the first firm to waive liability has double the normal risk. Waiving liability would alert customers to this unpleasant fact. But as long as the the firm cuts the price of parking by more than the customer’s expected $20 damages, disclaimers enrich both sides.

Regulators are usually loathe to allow disclaimers. Imagine how the U.S. government would react if an employer bypassed worker safety and discrimination laws with a “WORK AT YOUR OWN RISK” sign at the employee’s entrance. If pressed to justify their reluctance, regulators would probably respond, “Disclaimers would effectively gut the law.” They’re probably right. The upshot, though, is that the laws regulators are so eager to preserve are absurdly wasteful. If virtually every firm disclaims despite the adverse selection problem, the liability regime must be very inefficient indeed.