The Buck Stops Where? The Role of Limited Liability in Economics

Thomas H. Noe and Stephen D. Smith
Economic Review, Vol. 82, No. 1, 1997

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Over the last few centuries laws have increasingly protected individuals and corporations from liability resulting from bad economic outcomes. This evolution in liability provisions, by many accounts, has significantly influenced both the level and distribution of contemporary economic output as well as the allocation of financial resources in today's financial markets.

Through a review of an extensive and growing literature, the authors of this article consider how limited liability affects investment, labor, and financing decisions made by individuals and corporations as well as government policies intended to promote economic growth or redistribute wealth. The authors first examine conflicts that may arise in labor markets because of certain rights held by providers of human capital or because some assumptions about personal limited liability may not be compatible with sustained production. The discussion then considers how liability rules influence the incentives of debtors, creditors, and managers. Finally, the authors look at the role of limited liability in the relationship between government and private institutions as it relates to economic growth and the provision of liquidity to the banking system.

By providing an explanation of incentive structures under alternative liability regimes, this article should help policymakers better understand the possibly unintended effects of certain policies and programs.

March 1997