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Regulation Magazine

The Cato Review of Business & Government

Risky Products, Risky Stocks

Paul H. Rubin, R. Dennis Murphy, and Gregg Jarrell

Paul H. Rubin is vice president of Glassman-Oliver Economic Consultants and former
chief economist at the Consumer Product Safety Commission. R. Dennis Murphy is an
economist at the Federal Trade Commission. Gregg Jarrell is senior vice president of research,
the Alcar Group, Inc., and former chief economist at the Securities and Exchange Commission.
The authors' views do not necessarily reflect those of the commission.

At Least two types of information can show the worth of a firm: the accounting data that itemize assets and liabilities accounting to generally accepted accounting principles, and the price of its common stock. The stock market's valuation of a firm incorporates diverse information that accountants must ignore-ranging from the health of the world economy to the health of the firm's marketing vice president.

The costs of regulation are often measured in accounting terms. This information is useful, but in many cases it fails to reveal certain large costs that are very much on the minds of stockholders. In this article, we examine the costs of product recalls by the Consumer Product Safety Commission (CPSC) as reflected in the market value of affected firms. With well-functioning capital markets, stock prices provide a measure of the full costs of regulatory actions on firms and their shareholders.

CPSC Recalls

The CPSC regulates all consumer products that are not specifically under the jurisdiction of other federal regulatory agencies. Since most dangerous products like automobiles, boats, buns, drugs, foods, cigarettes, and pesticides are regulated elsewhere, the CPSC is limited by law to regulating comparatively safe products.

Under the Consumer Product Safety Act, firms are responsible for informing the CPSC of "defective" products, which are defined as products that create "a substantial risk of injury to the public." Defects may be due to design problems that cause injury-a toy hung above a crib contrary to warnings. After filing a report, the firm and the agency's compliance staff generally negotiate over alternative course of action. Most often a plan of action is adopted "voluntarily" on the part of the firm and a joint press release is issued. If no agreement is reached, the CPSC can litigate. Depending on the agreement, the firm may pay refunds to purchasers, repair defects, replace items with non-defective units, or send warning notices to consumers.

Selected CPSC Toy Regulations

  • Small Parts. Toys used by children under 3 years of age must not contain small ingestible parts.
  • Sharp Points and Edges. Toys and other articles for children under 8 years must not contain sharp points or sharp glass or metal edges.
  • Pacifiers and Rattles. Pacifiers and infant rattles must be large enough so that babies cannot choke on them, and must not come apart into small pieces.
  • Lawn Darts. Lawn darts must not be sold in toy stores and must have labels to indicate they are not toys and could cause serious injury if misused.
  • Lead in Paint. The amount of lead in paint used on toys and other children's articles must not exceed .06 percent. This limitation also applies to paint sold for home use and to paint used on furniture (except metal furniture).
  • Hazardous Chemicals. Toys and other articles used by children must not be made with poisonous and otherwise harmful chemicals. Chemistry sets, model rocketry sets, model airplane fuel, and other products designed for older children, which by their very nature must have such chemicals, may be sold only if accompanied by instructions and warning labels.
  • Electrically Operated Toys. Electrically operated toys and children's products must be designed to prevent shock and burn injuries.

Source: U.S. Consumer Product Safety Commission, Product Safety Fact Sheet, No. 47: Toys" (August 1986).

The CPSC recalls about 200 products from the market each year, ranging form teakettles and hairdryers to snowmobiles and compressed gas cylinders. About half of the recalls involve violations of pre-existing CPSC standards, such as the health and safety rules for toys summarized in the box below. The rest involve unanticipated defects similar to the examples in the table on the opposite page. This article deals only with unanticipated defects.

Direct and Indirect Costs

Recalls impose both direct and indirect costs on the owners of firms. Direct costs include outlays for notices, repairs, refunds, and the like. These are the costs that would normally be measured in a benefit-cost analysis (were such an analysis conducted). Indirect costs, which are likely to be much larger, are associated with damage to the goodwill of consumers and the risk of product-liability suits. If consumers interpret a recall announcement to mean that a firm makes unsafe products, sales will suffer, as will the value of the firm's stock. Equity values will also be adversely affected if a recall signals a firm's increased vulnerability to liability suits.

Stock Market Response

With efficient capital markets, all available information is reflected in current stock prices; any new information, such as that provided by an unanticipated recall announcement, is quickly incorporated. Thus the cost to firms of product recalls can be measured by estimating the excess (or net-of-market) stock returns in a period surrounding the public announcement. Adjusting for market trends and for the riskiness of the particular stock, negative excess returns would imply that the firm was adversely affected by the recall, whereas positive excess returns would imply that the firm benefited. The magnitude of the excess returns provides a numerical estimate of the losses or gains borne by shareholders.

The sample of firms in our study is a subset of publicly traded firms involved in recalls for unexpected defects in the period 1977 to 1981. This sample covers 48 recalls for 31 firms. (Eight of the firms were involved in multiple recalls.) In examining the stock price effects, we used an 80-day event window spanning from 40 days before the recall announcement to 40 days after. This is large enough to ensure that any overreaction in the market to the news of the recall is corrected. Because our sample is limited to publicly traded firms, which are typically larger than average, our cost estimates should be higher in dollar (but not percentage) terms than the cost of the average recall. The sample of recalls is representative of CPSC recalls.

Recalls Impose Substantial Costs

On the basis of this research, we conclude that product recalls are very costly, resulting in large drops in the stock prices of affected firms. In the sample of firms studied, the average loss in equity value was 6.9 percent; on average, a firm loses about 7 percent of its net worth as a result of a product recall. Excess returns are negative in 73 percent of the cases examined. In dollar terms, the aggregate net loss from the 48 recalls was $7 billion. Six billion dollars of this total was due to one firm, Sears, which was involved in eight overlapping recalls. Even excluding Sears, losses averaged 5.4 percent of net worth, and excess returns were negative in 67 percent of the cases. Evidently the market imposes strong penalties on firms producing "defective" products.

These costs are much larger than we had expected. Most products recalled pose a relatively small risk, and the direct costs of the recalls themselves are usually small. For example, five of the cases in the sample involved hairdryers that were recalled for an extremely remote cancer risk from asbestos; even in these cases the stock price effects were generally negative.

While our estimates of the costs of CPSC recalls are surprisingly large, they are consistent with the results of studies of similar regulatory actions by other federal agencies. In a study by Sam Peltzman and Gregg Jarrell, for example, drug recalls by the Food and Drug Administration were found to result in a 6 percent loss in equity value, which is very close to the estimates here. Automobile recalls by the National Highway Traffic and Safety Administration were found to result in substantially smaller costs- about 1.4 percent of equity value. However, this lower figure appears to be due to the fact that automobile recalls are fairly common so the risk of a recall is generally anticipated. (A recent study by George E. Hoffer, Stephen W. Pruitt, and Robert J. Reilly questions this result.) In another study by Peitzman-the first event study of a regulatory action-deceptive advertising cases by the Federal Trade Commission were found to reduce the net worth of affected firms by 3 percent. This lower figure (though still high) reflects the less severe nature of the regulatory action, which is generally a cease-and-desist order.

Effects on Consumers

While the effects of product recalls on firms are interesting and important, ultimately we are concerned with the effects of government action on consumer welfare. Our analysis has two implications for consumers.

First, since the costs of recalls are ultimately borne by consumers, the net benefits of recalls are lower than might be indicated by numbers of lives saved, or sickness or injuries escaped. The CPSC imposes significant financial risks on firms producing consumer products and, consequently, increases their cost of capital. The higher the cost of capital, the higher will be the price of consumer goods.

Second, the health and safety benefits to consumers may not be worth the cost. A preliminary examination of the benefits of the recall program suggests that they are quite small. CPSC epidemiologists estimate that 25,000 deaths result annually from accidents involving all products under CPSC jurisdiction. Considering all recalls of defective products between 1984 and l986-there were 279 products recalled, of which 20 had a measurable potential for causing death-we estimate that no more than 25 lives per year are saved as compared to the 50 or fewer lives lost annually as a result of these recalled products. Two-tenths of 1 percent of the deaths from CPSC-regulated products are due to correctable defects. In a separate study, W. Kip Viscusi has found that the CPSC has had no measurable effect on reducing product-related deaths, a result consistent with our findings.

Analyses conducted within the CPSC have shown that for products that are recalled, the compliance staff is just as likely to underestimate a risk as to overestimate a risk. This can result in anomalous situations where relatively low-risk products are given more publicity and are regulated more strictly than high-risk products. For example, one of the most severe risks the CPSC has dealt with through a recall in recent years involved an electric heater that was associated with fires. The heater had been erroneously classified as less risky than a toy that presented a much smaller risk of death. This can occur because recalls are not subject to an ex ante qualitative risk analysis.

Unjustified recalls can lead to increased risk in the market. If products are erroneously removed form the market, consumers' choices are unnecessarily restricted, and consumers have an incentive, due to higher product prices, to continue using older, more dangerous products. In addition, if consumers are led to believe that products are more dangerous than they really are, they will shift their consumption toward other (possibly riskier) goods or activities. Finally, because of the large number of recalls, consumers may be led to believe that accidents typically result from design defects, rather than the care with which they use products. As a result, they may be lulled into excessive carelessness. Although these costs could not be measured in our study, ultimately they may be the largest and most important component of the cost of product recalls.

Policy Implications

Recall decisions are far more costly than generally recognized, and certainly far more costly than indicated by the direct costs. The benefits of recalls-lives saved, or injuries or sickness escaped-may or may not justify these costs. Only if the benefits of correcting a defect exceed the costs should the CPSC recall a product and impose these enormous costs on owners of firms and ultimately on consumers. Cost-benefit analysis is required to make such a determination.

For a short time, the CPSC conducted cost-benefit analyses to determine the best policy, but only in cases where an agreement had not been reached between the firm and the compliance staff. Since there are few contested cases at the CPSC, there were not many cost-benefit analyses. Perhaps agency staff resisted wider use of this technique because they believed very few recalls would be found to have benefits that exceeded costs. If this were the case, and if product recalls would generally impose net harm on society, cost-benefit analysis should be required, not avoided. To date, the CPSC has not compiled sufficient data to draw any firm conclusions about the social value of individual recalls.

Unfortunately, with the passage of the 1988 CPSC appropriation bill, it became illegal for the CPSC to use cost-benefit analyses to determine if a recall will provide net benefits to consumers. The bill forbids the CPSC from spending any funds "conducting or reviewing cost-benefit analyses on enforcement actions." This provision should be repealed. All decisions regarding product recalls should be evaluated using a cost-benefit analysis. In the meantime, the CPSC should be very restrained in issuing recall announcements.

Sound public policy would dictate that the CPSC also give serious attention to reallocating resources within the recall program, and quite possibly, to reallocating resources away from the recall program to other activities. The goal should be to save more lives at lower social cost.

Another public policy implication of our analysis is that the CPSC should issue a Federal Register notice clarifying a statement it has made urging firms to report possible defects and suggesting that voluntary recalls may be beneficial to firms. According to the CPSC, "corrective action voluntarily undertaken by a firm has the beneficial effect of showing that the firm is responsible and concerned about high standards of quality." By suggesting that the costs of recalls are lower than they actually are, the CPSC could induce firms to under-invest in safety and hence produce too many defective products.


The CPSC spends about 15 percent of its resources on recalls, even though the defective products involved cause no more than two-tenths of one percent of the deaths associated with products under CPSC jurisdiction. This allocation of budget resources might be appropriate if, for example, defects were more easily addressable than other hazards. However, the evidence suggests that this is unlikely. Recalls impose large costs on firms and ultimately on consumers. Furthermore, given the large number of recalls(the CPSC may issue several messages a week about defective products), consumers may be led to believe that accidents are caused by defects rather than careless use, possibly resulting in increased risk. At present the CPSC has no way of determining which defects are most severe and most deserving of attention.

The only way to correct these problems is to perform quantitative analyses of the costs and benefits of all CPSC actions. This would enable the CPSC to improve the allocation of resources, and consumers could have greater confidence that products recalled for defects in fact had defects worth correcting. The current congressional ban on such analyses does not benefit consumers, does not increase safety, and should be removed.

Selected Readings

Hoffer, George E., Stephen W. Pruitt, and Robert J. Reilly. "The Impact of Product Recalls on the
     Wealth of Sellers: A Reexamination," Journal of Political Economy, Vol. 96, No.3 (1988).
Peltzman, Sam. "The Effects of FTC Advertising Regulation," The Journal of Law and
(December 1981).
--, and Gregg Jarrell. "The Impact of Product Recalls on the Wealth of Sellers," Journal of
     Political Economy
, Vol. 93, No.3 (1985).
Viscusi, W. Kip. "Consumer Behavior and the Safety Effects of Product Safety Regulation," The
     Journal of Law and Economics
(October 1985).
--, Regulating Consumer Product Safety. Washington, D.C: American Enterprise Institute, 1984. Wilson, Richard and Edmund Crouch. Risk/Benefit Analysis. Cambridge, MA: Ballinger
    Publishing Company, 1982.

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