Ex ante investment, ex post remedies, and product liability

A firm can increase product safety through ex ante investment and can remedy quality problems after sales. An increase in product liability raises returns to ex ante investment through higher consumer demand, but may also negatively affect the investment incentive due to more ex post remedial activities. The trade-off between these "output" and "substitution" effects can result in an inverted U-shaped relationship between product liability and ex ante investment. We find that the firm prefers full liability, but consumer surplus can be higher under partial liability. We further identify conditions under which full liability or partial liability is socially optimal.