This article analyzes, in terms of various regulatory
mechanisms (including post-surveillance approval and partial or strict
liability), a pharmaceutical firm’s R&D investment and recall
decisions. In the model, while the total amount invested in developing
a new drug is common knowledge, the safety and efficacy of the drug are
uncertain. After initial purchase, the firm and consumers automatically
learn efficacy, while, unlike the firm, consumers cannot infer the
level of safety. Hence, the firm is able to ascertain the safety of the
drug more rapidly than consumers. We show that, in this environment,
the firm may not make the socially optimal R&D and recall decisions. We
then characterize the regulatory mechanism that induces the socially
optimal outcomes.