Tuesday, September 22, 2009

CPSIA - How Much Should We Pay to Prevent "Cheating"?

I was contacted today by an ex-CPSC'r who read my blog on Section 102(d)(2)(B) and wanted to point out that sometimes people lie and cheat when it comes to disclosure to the agency.

So the question is: if people might pull the "switcheroo" or otherwise commit intentional fraud, wouldn't the right solution be to make everyone test under much more controlled and regulated circumstances? This might make things much harder for cheaters. Isn't that good?

My response is NO. First of all, I hope it is no surprise to you or anyone that some people cheat. I believe this was discussed in the Bible and frequently thereafter. This MIGHT be the reason we have a criminal code and JAILS. Some people are also incompetent. They don't cheat, they just fail repeatedly but goodnaturedly. The rest of us work hard and get our jobs done. As for me, although some people might cheat, I do NOT. If all the honest people must pay a high certain price in order to squeeze out the bad guys, we will all be crushed. This is akin to being treated like a murderer - just because there have been murders in your town. The CPSIA punishes the many for the sins of the few.

The dispiriting idea underlying the lunkheaded Section 102(d)(2)(B) is that no one can be trusted, and that unless the government gets involved in regulating the minutia of safety testing, we cannot be sure that everything will be okay. [Did you ever think about why the CPSC must now accredit testing labs? We never needed it before - what precipitated the change? I am not aware of a single recall that was blamed on an incompetent or fraudulent lab. This is all the more troubling when you consider how much money has been wasted on this pointless and growing devotion of CPSC resources.]

The economics of over-regulation are poor. Investment incentive is crushed by excessive regulatory costs as a profit motivation is rendered moot. In this case, we are CERTAIN to bear excessive costs for needless and pointless testing, all because a panicked Congress' felt an urgent need to "do something" about recalls. What costs will be eliminated as a result? If our company has to pay 2-5% of our revenue for compliance with this new law (my estimate), can we save that much or more in avoided costs? Not based on our 25-year track record (recalled 130 pieces out of a billion in 25 years, or 0.000013% per annum). We now must trade an annual cost increase of 2-5% for an annual savings of 0.000013%. What about the costs to society? Well, in our case, all 130 pieces were recovered and there were no known injuries. Cost to society: zero. This is not so crazy, as less than 0.01% of all children's products are ever recalled. Consider the famous lead-in-paint recalls of 2007-8: 125 recalls, no deaths and only one claimed injury (from a crib).

So, who will pay for this folly?


Some myths need to be dispelled:

a. America pays the costs of the CPSIA. This is simple economics. The law of land regulates us a community. We pay for all recalls and we incur the costs of all injuries. Although costs may be shifted (reallocated) among us by law (some winners, some losers), ideal laws lower our net societal costs by incentivizing the most efficient allocation of resources. Thus, a law might assign one party to bear a responsibility because they can manage it at the lowest overall cost, thus avoiding significant and greater costs by a less efficient party. Common examples of this are torts (the law places strict burden for product liability on manufacturers) and railroad crossings (railroads must pay for safety of the crossings). Manufacturers and railroads are in the best position to protect against safety dangers, as opposed to consumers acting individually. If manufacturers and railroads weren't allocated this responsibility, consumers would bear too much cost (inefficiently) in the form of injuries or losses. This is nothing more than a law-and-economics explanation of how legal systems work. See "The Problem of Social Cost" by Ronald Coase (Coase received the Nobel Prize for this theory). In the bargaining world hypothesized by Mr. Coase, costs would be borne by the party best able to bear them efficienlty, which might be manufacturers . . . or might be consumers.

[It also is clear that no matter what happens to the CPSIA (be still, my heart!), manufacturers will still have a strong incentive (by law) to make their products as safe as possible. Tort law provides this economic incentive quite well.]

b. NOT all recalled items are "deadly". Some recalls have the potential to kill, but most do not. Of the simple "risk of injury" recalls, many are technical violations (immaterial threats of injury), theoretical risks, or worst of all, self-imposed (sometimes companies insist on recalls over the objection of the CPSC). It is plainly WRONG to contend that recalled items are "deadly" (Ahem, Ms. Tenenbaum).

c. We cannot simply "raise" our prices to cover the new costs. Products have a strong "perceived value" which cannot be overcome with marketing. Some items are quite price sensitive. How much would you pay for your Starbucks latte? If the price went over $5, would you change coffee shops? $6? $8? No one is indifferent to price. How much would you pay for napkins at McDonalds, given that you probably think you are entitled to free napkins? Most people would cut their napkin use by 90%+ if the cost was as little as 1 cent each. This reasoning applies to ALL products and ALL services, no exceptions (even medical care). In the case of toys, many toys are commodities and have essentially a known "market value". If you price them too high, you will lose business. "Perceived value" is set or heavily influenced by the mass market, precisely the part of the children's market most able to absorb new CPSIA costs. Those of us in the specialty markets are toast as a consequence.

d. The right way to measure recall effectiveness is in their economics. As noted above, we Americans will bear the net cost of this law. Is it worth it? We know that some items subject to recall present "unacceptable" risks of injury and others do not. It has always been the common sense practice of the CPSC (until recently) to exercise judgment when imposing a recall. They used to recognize that recalls come at a cost.

There are many factors to assess in determining that a recall is merited. Having never been a CPSC manager or a legislator (heaven forbid!), please take my amateur's list of factors with a grain of salt: (i) nature and severity of the risk of injury, (ii) number of units in circulation, (iii) age of the child subject to the risk, (iv) public policy [Is there a reason to justify strict liability? This would presumably be infrequent.] and (v) durability and value of the recalled item. Common sense dictates that you must weigh the benefits of a recall against the economic damage wrought by the recall. Since we finance both sides of the ledger, we Americans have an incentive to behave rationally and take the lowest cost route. [The Coase Theorem again.]

If you think about the case where one "dangerous" children's product (say, a pair of shoes) is in circulation somewhere in the United States, it probably wouldn't be worth the significant expense of recovering that special pair of shoes unless we knew that one or more lives were DEFINITELY at risk, a very high cost. [Exploding shoes, perhaps.] Thus, if some situations present low grade risk of injury and a high expense for a recall, it may sense to NOT expend the money on a recall, but perhaps to engage in other activities to keep costs down (like education or a "running" change in product design). Let's also not forget that manufacturers that go through a CPSC process incur meaningful "transaction" costs even if there is NO recall (i.e., legal expenses, possible inventory loss, embarrassment, etc.). Thus, even without penalties, there is an incentive to do better next time - a recall is not needed to get most companies to straighten up.

Given my estimate that we will expend 2-5% of revenues to comply with this awful law, could the economics ever justify that expense to save "injuries"? You already know that we incur an anticipated annual expense for recalls of 0.000013% of revenue, all to avoid a 25-year injury rate of zero. This annual "CPSIA tax" of 2-5% is entirely "inefficient" in a Coase sense, as the imposition (and allocation) of costs is irrational. This completely explains why the law is misconceived. Since the CPSC is not allowed to exercise judgment under the CPSIA, and since economics are not allowed to be considered either, it is by definition an irrational and shamefully inefficient law. Mr. Coase would be outraged.

I happen to be outraged, too. Cheaters frustrate me but that's no justification for treating everyone like they are cheaters. It's time to rewrite the law to permit the cheaters to be treated like cheaters, and leave the rest of us ALONE.


cmmjaime said...

Well put as usual. It is a shame that those "in charge" of CPSIA can't seem to think it through as well...or won't listen to those who have thought it through.

Please keep up the good work.

bchiasson said...

There is no sense of urgency for Congress or Ms. Tenenbaum because they have been lulled to sleep by the silence from all but a few business owners. Why? Because most small businesses don't understand the complex and ambiguous language in the CPSIA. They find it easier and more comforting to believe that the law doesn't apply to them than to shell out half their annual net profit to get legal advice from their general counsel. Counsel who often has little expertise in such matters or is utterly befuddled by the provisions in the CPSIA. I can't tell you how many times I received legal advice that sounds like this, "...well, no one is sure what Congress meant by that statement, or....the CPSC hasn't yet issued guidance on that topic, or..."...we don't know what advice the CPSC is going to give on that issue (on a CPSIA provision that goes into effect in a few weeks). It's not because our legal counsel is ignorant. It is because the CPSIA was ignorantly authored.

Tens of thousands of small and medium-sized businesses are quiet because they are either (a) not informed about the CPSIA (what, have they been living under a rock?); (b) in denial and believe this will all blow away; or, (c) scared to death to speak out about such a horrible topic as they are in fear of the government targeting them for audits or other financial punishment.

The industry's silence should not be mistaken for a lack of need or urgency to fix this crushing legislation. Make no mistake; Americans will lose jobs; businesses will shut down; and the school supply market will evaporate.

Marianne said...

What about the concept of "innocent until proven guilty?". Because a small few have "cheated" the system, it appears the entire children’s product industry has to pay.

You make a strong point about "perceived value" as it pertains to many manufacturers, brands, and retailers. Our store competes with the perceived value mass marketed/big box stores, yet our customers come to us for the unique products we carry and are willing to pay more for these. Now with CPSIA, MANY of our unique brands are in jeopardy because like you point out, we can't just roll the extra costs onto the customer. With the costs of CPSIA to manufacturers, we would have to price many one-piece bodysuits in the $50's or $60's. Can you imagine?

I also agree with the comment that most small businesses STILL don’t understand this law. It is annoying and hard to believe that many manufacturers, resellers, and retailers are unaware or unconcerned about the law. But I keep saying, until CONSUMERS feel it, experience lack of products and diversity…nothing probably will change.

Thank you Rick for getting attention (in whatever form it takes) to this law. I still believe we all will be heard.

Headmistress, zookeeper said...

It's like giving everybody an antibiotic because some people get infections, or having CPS take away everybody's children because some children are abused.

Kathleen Fasanella said...

I fear that certain groups will use the figure of 2%-5% to their advantage ("Manufacturers think children's safety isn't worth two cents"). To anyone with that perspective I bring up two points.

First, this is Rick's *estimate* as it applies to his firm which has considerably better economies of scale than most of the tiny enterprises that are undone under CPSIA. LR also has (comparatively) robust, sophisticated tracking systems which are expensive to purchase, implement and maintain, further lowering myriad costs over all. Few small businesses (as most children's related businesses are) have the money, staffing or acumen to use them. The costs of compliance for smaller businesses are closer to 30%-50% or more.

Second, there is no nice way to say this but critics who have never owned a business don't realize that "2% to 5%" is a fortune. That figure can exceed a firm's total profit margin removing the incentive to be in business altogether. Perhaps advocates for CPSIA should think of "2% to 5%" in terms of a mortgage. Adding 5% to the interest on your mortgage amounts to a 50% increase in your monthly payment on a 30 year note. "2% to 5%" must be considered in the proper context.

Then again, perhaps critics would frame the issue in terms of "Is the widespread unemployment of children's caretakers worth two cents?" Already, half the poor people in this country are children, is that not enough? That said, it is a false choice to suggest the better option is "safe but hungry" even if you believed it to be true because CPSIA does but little to balance the veritable stakes of all parties in the children's safety "game".

Rick Woldenberg, Chairman - Learning Resources Inc. said...

I agree with Kathleen on several levels. It is true that our company already had a considerable investment in safety, software, systems and people, all of which allow us to manage the excessive new safety costs relatively well. In addition, we have a strong understanding of the law and have been spending money on lawyers and so on to make sure our investment in our business is protected. Our approach is probably not representative of the market at large.

That said, I would like to add to Kathleen's comment on the 2-5% estimate I have used for the incremental safety costs. She is probably right that we estimate our costs lower than other companies will experience. I also may have estimated low. We won't know for awhile.

As to the notion that safety must be "worth" 2-5 cents, I think that is the wrong way to look at it. First of all, the COST of that "safety" in term of recall expense and injury is far less than 2-5 cents per revenue dollar. I explained that in my essay, and noted that it is irrational to spend 50,000x the cost of the injury to prevent it. This is simple economics and explains how people actually behave. Do you wear a helmet when you walk down the street because you know meteors hit the Earth several times a year? Why not take this "inexpensive" precaution against a meteor hitting you on the head? Well, you are not crazy if you instantly recognize that this solution is excessive relative to the risk. If a meteor hit you on the head, you would die. That's costly, to say the least, BUT I am certain you would still not choose to overpay to "control" this risk. You correctly discount the high cost of this prospective injury by the chances of it occuring to you, which is basically nil. In fact, were you to really take the meteor risk seriously, you would presumably stop getting out of bed in the morning. It's much safer under your covers.

There is another way to look at the 2-5 cents that is even more important. How much revenue do you need to make to produce 2-5 cents of profit? For many small businesses, the NET profit they make is only 5%. Businessmen tend to think that this profit is produced ratably per dollar of revenue. In other words, they believe that costs are ratable to revenue, and rise and fall with revenue. This is an approximation, obviously, but is a good working model for a business. So, to me, the 2-5 cents of incremental expense has to be borne by enough incremental revenue to cover it in additional net profit. So, for a company that produces 5% net profit, 2 cents of incremental cost requires 40 cents of revenue, and 5 cents of incremental expense renders your business PROFITLESS.

In this model, paying 2 cents for profit substantially reduces the incentive to work night and day to keep your business going. Remember the example of the $3,000 incremental test cost in my Sept. 21 "Brace for it . . ." post? If your business produces $80,000 in revenue for this item, you will now make an inspiring $1,000 in net profit with this incremental cost. That's a LOT of work to produce very little profit. Surely there must be a better way to make a living. This is the problem with the notion that safety must be "worth" 2 cents.

Safety is worth the expense if the investment is favorable for our society as a whole. We as a community pay the cost of prevention and bear the cost of injuries. Good public policy (law-making) will create rules that minimize the net expense to our society. That's the principle that won Mr. Coase his Nobel Prize for Economics. It is also a foundation stone of modern economics and it is right.