The Geneva Papers on Risk and Insurance, 21 (No. 79, April 1996) 182-203 The "Polluter Pays Principle": Should Liability be Extended When the Polluter Cannot Pay? by James Boyd and Daniel E. Ingberman * 1. Introduction When pollution causes a social loss, who should be liable? Common sense, standard legal doctrine, and notions of economic efficiency agree that liabilities should in general be assigned to the polluters; that is, the polluter should pay. When the polluter's wealth is insuf- ficient to pay all damages, however, liability is often extended beyond the direct polluters to more passive parties who merely contract or transact with the polluter. The underlying motivation for extending liability is cost internalization: extending liability expands the capital available to compensate victims and, by forcing greater joint cost internalization and monitoring, can be expected to induce more efficient safety investments. As an example of this vie Hansmann and Kraakman (1991) have argued that there should be unlimited shareholder liability for corporate torts. And Skogh (1991) identifies the beneficial role that financial intermediaries can play in monitoring and signalling the safety or quality of firms they guarantee. The rationale has also been put forward in the literature on vicarious liability (the liability of principles for the actions of their agents), as in Sykes (1984) and Kornhauser (1982) 1 Is the logical conclusion, then, that liability should always be extended in order to maxi- mize the internalization of liabilities and promote optimal risk reduction? We show that the answer is no. The prospect of being liable for the actions of another can affect the organiza- tion and performance of markets. Extended liability can reduce efficiency if, for instance, * Boyd is a Research Fellow at Resources for the Future, 1616 P St. NW. Washington, DC 20036. Tngberman is Associate Professor at the John M. Olin School of Business, Washington University. St. Louis, Missouri 63130-4899. For their comments, we thank Nick Dopuch, Phil Dybvig, Ron King, Göran Skogh, the anonymous referees, and seminar participants at Washington University, the 1994 American Law and Economics Association meetings, and the 1995 joint meetings of the Geneva Asso- ciation and the European Association of Law and Economics. I Like Skogh, but in contrast to the literature on vicarious liability, our analysis features risk- neutral contracting parties. 182