Liability and organizational choice

Scholars have long maintained that increases in liability encourage firms to contract out risky activities in order to take advantage of so-called judgment-proof strategies. These strategies allow entities to limit their liability through contractual arrangements with nearly insolvent firms. However, the use of judgment-proof firms triggers countervailing effects: it provides opportunities to externalize liability through judgment-proof firms, but the insolvency of these firms introduces distortion in care levels that can generate more liability costs. These costs may outweigh the benefits of externalizing liability, making contracting out suboptimal. A simple model of organizational decision making with judgment-proof firms is developed and applied to the oil industry, where contracting out decreased in response to heightened liability following the Exxon Valdez oil spill.