Cost Benefit Analysis of Consumer Protection Programs

Rachel Dardis, University of Maryland (student), University of Maryland
Diane Myman,
ABSTRACT - There has been increased interest in consumer protection including consumer product safety standards in recent years. This paper investigates the role of cost-benefit analysis in determining whether mandatory safety standards are in the public interest and applies such analysis to an evaluation of flammability standards for children's sleepwear and clothing.
[ to cite ]:
Rachel Dardis and Diane Myman (1977) ,"Cost Benefit Analysis of Consumer Protection Programs", in NA - Advances in Consumer Research Volume 04, eds. William D. Perreault, Jr., Atlanta, GA : Association for Consumer Research, Pages: 121-125.

Advances in Consumer Research Volume 4, 1977   Pages 121-125

COST BENEFIT ANALYSIS OF CONSUMER PROTECTION PROGRAMS

Rachel Dardis, University of Maryland

Diane Myman (student), University of Maryland

[Financial support from the National Science Foundation, Research Applied to National Needs, is gratefully acknowledged.]

ABSTRACT -

There has been increased interest in consumer protection including consumer product safety standards in recent years. This paper investigates the role of cost-benefit analysis in determining whether mandatory safety standards are in the public interest and applies such analysis to an evaluation of flammability standards for children's sleepwear and clothing.

INTRODUCTION

Deaths and injuries involving consumer products pose serious social and economic problems in the United States. It is estimated that approximately 20 million Americans are injured each year in the home as a result of accidents involving consumer products. These accidents result in 30,000 deaths while 110,000 persons are permanently disabled (National Commission on Product Safety, 1970). The Consumer Product Safety Commission was established in 1973 in response to public concern for product safety. The Commission was granted broad authority to issue and enforce safety standards over more than 10,000 products.

The necessity for mandatory standards is based on several factors. First, the consumer may be uninformed of the underlying hazard and hence may not perceive the need for protection. Secondly, the consumer who elects to live dangerously may also be exposing others to the same risk, e.g., a cigarette smoker who involves others in a fire. The increased interdependence of consumption which characterizes a modern industrial society means that the "right to choose" and the "right to safety" are sometimes in conflict. Finally, part of the costs of accidents is incurred by the taxpayer rather than by the individual. In both the second and third instances, un-derevaluation of potential benefits by an individual consumer may result in a less than optimum level of safety for society as a whole.

In the case of mandatory safety standards, however, the determination of the appropriate level of safety is a major problem, since decisions are made outside the marketplace. Weston, while acknowledging the necessity for safety standards, cautions that the "formulation of new standards should compare trade-offs between degrees of safety, alternative methods of achieving them, additional costs and their effect on consumer usage and relate all of these to the potential benefits". (Weston, 1970, p.160). One technique for estimating the gains and losses from consumer protection programs is cost-benefit analysis.

In cost-benefit analysis, the costs of the program (generally measured by the value of goods and services foregone due to resource diversion) are compared to the benefits expected from the proposed program (generally measured by the prices that the beneficiaries would be willing to pay). The distribution of costs and benefits is not considered nor is it required that the gainers actually compensate the losers (Harberger, 1971; Mishan, 1971). Thus, total costs are compared to total benefits irrespective of their actual or potential distribution.

COST OF SAFETY STANDARDS

The direct cost of safety standards is the cost incurred by producers and consumers due to product regulation. Consumer costs include a reduction in product choice, higher price, reduced wear life, and safety maintenance costs. In most instances, the safety standard has the same impact as a tax and its burden depends on demand and supply conditions in the marketplace. In addition, there are indirect costs associated with a safety standard which are more difficult to quantify. For instance, regulation may reduce the number of firms in an industry due to the inability of some firms to establish the necessary quality control procedures. Another potential indirect cost relates to innovation. Innovation may be discouraged if manufacturers believe that new products will be unable to meet existing safety standards or may be required to meet new standards. In both instances, there will be a reduction in competition and in product choice in the market- place.

Product Removal

The removal of existing products due to product safety regulations entails a cost which may be assessed by comparing the consumers' willingness to pay for the product prior to its removal to its cost of production. The initial situation is shown by point a in Figure 1 where D and S represent the market demand and supply curves respectively. The equilibrium price and quantity are given by Pa and Qa respectively and the consumers' willingness to pay for the quantity Qa is given by the area QQab. The net benefit to society from the production of Q units is given by abc since production costs are equal to OQaac.

FIGURE 1

IMPACT OF PRODUCT REMOVAL

Cost Increase

A cost increase due to a safety standard has an impact similar to a tax. The impact of a price increase is illustrated in Figure 2. The market demand and supply curves are given by D and S respectively, resulting in an equilibrium price and quantity of Pa and Qa. The imposition of a safety standard shifts the supply curve from S to S' reflecting an increase in production costs. The market price increases from Pa to Pb while the quantity declines from Qa to Qb. A loss is incurred by both producers and consumers in the short run. Consumer loss is measured by the change in consumer surplus due to the price increase from Pa to Pb. It is equal to the area of PaabPb. The loss in producer surplus is given by the area PccaPa.

FIGURE 2

IMPACT OF COST INCREASE IN SHORT RUN

In the long run, changes must occur in the producer sector since the price increase in the marketplace Pb - Pa is not equal to the increase in production costs Pb B Pc. Firms incur a loss and exit until the price increase is sufficient to cover production costs. This is illustrated in Figure 3 where S" reflects the market supply curve after exit of firms has occurred. The difference between the long run equilibrium price Pd and original price Pa is equal to the cost increase imposed by the safety standard (Pb - Pc). The loss in consumer surplus in the long run is given by the area PaadPd. There is no loss in producer surplus in the long run since all resources are variable.

FIGURE 3

IMPACT OF COST INCREASE IN LONG RUN

The relationship between short-run and long-run costs depends on demand and supply conditions in the marketplace. If supply is perfectly elastic, then the initial price increase in the marketplace Pb - Pa is equal to the increase in production costs and there is no further increase. In this instance, short-run costs and long- run costs are identical. If supply is less than perfectly elastic then short-run costs are greater than long-run costs since the producer can reduce costs by exiting in the tong-run.

BENEFITS OF SAFETY STANDARDS

There are two major methods for estimating the benefits of safety standards. The first method, value of a livelihood, focuses on the direct and indirect costs of accidents to society and estimates the benefits to society from a reduction in accidents. The second method, willingness to pay, focuses on the consumers' willingness to pay for risk reduction. To date, methodological considerations have favored the use of the first method.

The direct costs of accidents include property damage, medical costs, legal and administrative costs, and accident investigation costs. The indirect costs are the output losses resulting from accidents and the pain and suffering incurred by the victim and his family. Measurement of output losses takes into consideration valuation of output including services of housewives, treatment of consumption costs, labor force participation and employment rates, and the appropriate rate of discount. Output is generally measured by the mean wage earnings of members of the labor force. Valuation of the services of housewives presents problems however. If services of housewives are valued at the mean earnings of household workers, an underestimation of indirect costs may result. The opportunity cost concept of being a housewife may also be employed with full-time female earnings providing an imputed value for services of housewives. Treatment of consumption costs varies according to whether the loss to society is under consideration rather than the loss to the individual family. In the latter case, the value of consumption is deducted from the earnings of the individual.

In the case of death or permanent disability output is measured by the present value of future earnings. In this manner, future income is converted to the same period of time. While the necessity for discounting is evident, there is disagreement concerning the appropriate rate of discount. Most studies have employed a range of discount rates varying from 4% to 8%. The present value of future earnings is given by the following formula:

EQUATION   (1)

where

Va = present value of future earnings of an individual aged a

a = age of victim at the time of the accident

n = age of retirement from the labor force

paj = probability that an individual aged a, will survive to age j

Wj = probability that an individual aged j, will be in the labor force and be employed at age j. It is based on labor force participation rates and employment rates for each age group.

Yj = earnings at age j

and

i = discount rate

In the case of women not in the labor force and housekeeping Wj and Yj pertain to probability of housekeeping and housekeeping earnings.

The willingness to pay approach avoids some of the measurement problems associated with the value of the livelihood approach. It investigates how much the individual is willing to pay for risk reduction (or alternatively, how much compensation the individual requires for an increase in risk). While this approach has merit in that it leaves the value of life and hence of risk reduction to the individual, it may also result in an underestimation of benefits if externalities exist. There are also methodological problems in obtaining information. Market data are limited and consumer ignorance of product hazards may obscure the results.

Degree of Protection

The degree of protection afforded by a particular safety standard is important in determining the potential benefits. Thus, a 75% degree of protection means that society will save 75% of the direct and indirect costs of deaths and injuries. If information is limited concerning the degree of protection afforded by a standard then cost-benefit analysis serves to indicate the degree of protection required for a particular cost-benefit ratio.

APPLICATION OF COST-BENEFIT ANALYSIS TO FLAMMABILITY STANDARDS FOR CHILDREN'S SLEEPWEAR AND CLOTHING: SIZES 7-14

Cost-benefit analysis was applied to an evaluation of actual and hypothetical flammability standards for children's sleepwear and clothing respectively. Only the direct costs of the standards were included since information concerning the impact of flammability standards on the degree of competition and innovative activity in the textile/apparel industry is limited. However, this impact is likely to be minor since only a small segment of the apparel industry is involved. Estimation of direct costs was based on the assumption that existing products could be modified to meet the requirements of the standard so that only the impact of a cost increase was measured. Cost-benefit ratios were obtained for the year 1975.

Estimation of Costs

The estimation of the direct costs of the sleepwear standard is based on the assumption that supply is perfectly elastic. Thus short-run costs are equal to long run costs and only the change in consumer surplus is considered. Justification for the assumption of perfectly elastic supply is based on the absence of barriers to entry in the apparel industry and the ability of sleepwear manufacturers to switch production from sleepwear to other merchandise categories. Support for the assumption is provided by the fact that price increases for children's sleepwear have corresponded to price increases for apparel in general since 1975.

The change in consumer surplus due to the imposition of a flammability standard is given by the following formula:

DPQ - 1/2DPDQ   (2)

where

DP = change in price due to the imposition of a flammability standard.

and

DQ = change in market quantity due to the imposition of a flammability standard.

The above expression may be simplified as follows:

DPQ = (DP/P)PQ = tV   (3)

and

1/2DPDQ = 1/2t2ndV   (4)

where

t = DP/P

V = PQ

nd = price elasticity of demand

and

P,Q = market price and quantity respectively before the imposition of the flammability standard.

The cost to the consumer is then given by:

tV(1 - 1/2t nd).   (5)

The estimate of t is based on the percentage increase in price due to the flammability standard. Prices were obtained for flame retardant (FR) and non-FR merchandise of similar appearance and quality using leading mail order catalog price data. Prices for non-FR merchandise in 1975 were obtained by inflating 1973 prices by the relevant component of the Consumer Price Index. The resulting prices were compared to 1975 prices for FR merchandise in order to obtain the market price increase due to the standard. In addition, manufacturers and store buyers were consulted concerning the impact of the standard. It was concluded that the flammability standard had increased garment prices by approximately 30%.

Information concerning the price elasticity of demand for sleepwear is lacking. A unitary elasticity of demand for sleepwear was assumed in this study and resulted in a change in consumer surplus equal to PQ(0.26). If an elasticity of demand equal to two were employed, the change in consumer surplus is equal to PQ(0.28) which is a relatively minor increase. Sleepwear expenditures were based on the results of the 1960-61 Consumer Expenditure Survey. These expenditures were adjusted by price and quantity factors to provide 1975 estimates of non-FR sleepwear expenditures for sizes 7-14($200.45 million). The change in consumer surplus was $52.12 million.

It was assumed that the clothing standard would also in crease prices by 30% in the long run. Two assumptions were made concerning supply conditions for children's clothing. In the first instance, a perfectly elastic supply curve was assumed. Short-run costs, which are equal to long-run costs, were equal to

tV(1 - 1/2t nd   (6)

where

t = percentage increase in price in the long-run

nd = price elasticity of demand

and

V = clothing expenditures prior to the imposition of a flammability standard.

A unitary elasticity of demand was assumed. In the second instance, an elasticity of supply equal to one was employed. This meant that the consumer would bear 50% of the cost increase in the short-run and 100% of the cost increase in the long-run.

Short-run costs were equal to

rV(1 - 1/2t nd(1 + nd/ns))    (7)

where

ns = price elasticity of supply

and the other terms are as defined earlier.

The ratio of short-run costs to long-run costs is then given by

EQUATION   (8)

for nd = ns = 1 and t = 0.30.

Clothing expenditures were also based on the results of the 1960-61 Consumer Expenditure Survey and adjusted for price and quantity factors to provide 1975 estimates of non-FR clothing expenditures for sizes 7-14 ($4,707.34 million). Costs were $1,223.91 million and $1,331.61 million for perfectly elastic and unitary elastic supply conditions respectively.

Estimation of Benefits

The estimation of benefits was based on the potential reduction in burn injuries and deaths in 1975 due to the imposition of flammability standards. Estimates were first obtained for total burn injuries and deaths in the United states from the National Center for Health Statistics. Data were collected prior to 1975 in order to avoid an underestimation of benefits due to the introduction of the 7-14 Children's Sleepwear Standard in 1975. The data were then multiplied by the percentage of burn injuries and deaths involving clothing and sleepwear prior to 1975 and combined with population data to yield rates per 100,000 for burn injuries and deaths involving clothing and sleepwear. These rates were then applied to 1975 population data to provide an estimate of potential benefits. Data concerning the involvement of clothing and sleepwear in burn injuries and deaths were obtained from the Consumer Product Safety Commission (1974), U.S. Department of Health, Education, and Welfare (1970,1971,1972), National Bureau of Standards (Sharman,. 1972), National Burn Information Exchange (Feller, 1969), and the National Fire Protection Association (1969).

It was estimated that there were 5,500 and 2,420 burn injuries involving clothing and sleepwear respectively in 1975. The indirect cost of burn injuries were not calculated since it was assumed that injuries to children aged 6-12 would not interfere with productivity when they entered the work force at age sixteen. The direct hospital costs of burn injuries were obtained from the U.S. Department of Health, Education, and Welfare (1970, 1971). It was estimated that the average hospital cost of a burn injury in 1975 was $10,804. The remaining medical costs were based on 1963 and 1975 Health Care Expenditures published by the Social Security Administration, which indicated that hospital costs accounted for approximately 58% of the medical costs of injuries. Total medical costs were thus $18,583 per burn injury. Total medical costs for all clothing and sleepwear burn injuries were $102.21 million and $44.97 million respectively.

Fire and flame deaths were obtained for males 6-9 and 10 -12 and females 6-9 and 10-12 since the present value of future earnings is affected by age/sex classifications. Estimated clothing and sleepwear deaths and the present value of future earnings for the four different groups are given in Table 1. The estimated number of deaths for both clothing and sleepwear is considerably lower than the estimated number of injuries.

TABLE 1

ESTIMATED DEATHS IN 1975 AND PRESENT VALUE OF FUTURE EARNINGS BY AGE AND SEX

Earnings for females are lower than males in both age groups reflecting both lower labor force participation rates and lower labor force earnings for females. While provision was made for the services of housewives, such services were valued at the mean earnings of household workers which also served to depress earnings. The results also indicate the importance of the discount rate. The higher this rate the lower the present value of future earnings and the smaller the potential benefits from death reduction programs.

The direct cost of death was not calculated due to lack of adequate data concerning length of hospitalization of burn victims. The average direct cost, however, is likely to be relatively minor in comparison to the average indirect cost, i.e., the present value of future earnings. It must also be remembered that a certain number of victims expire prior to admission to the hospital so that little if any hospital costs are incurred by such patients.

The losses due to clothing and sleepwear burn deaths are given in Table 2.

TABLE 2

ESTIMATED LOSSES DUE TO CLOTHING AND SLEEPWEAR BURN DEATHS

Losses range from $2 to $3 million for sleepwear and from $5 to $9 million for clothing, when discount rates of 4% and 6% are employed respectively. Losses for both categories are considerably smaller than those associated with injuries ($45 million for sleepwear and $102 million for clothing). These results suggest that problems associated with measuring the "value of life" including the selection of an appropriate discount rate may he relatively unimportant when injuries dominate accident statistics.

The final loss component is pain and suffering which pertains to both injuries and death. Lack of adequate data prevented the inclusion of such losses at this time. However, provision may be made indirectly for such losses by increasing the permissible cost-benefit ratios. Thus cost-benefit ratios of two or three may be acceptable if such ratios reflect the omission of pain and suffering.

Cost-Benefit Ratios

Cost-benefit ratios for flammability standards for clothing and sleepwear are given in Table 3. The ratios are greater than one indicating that costs exceed potential benefits in all instances. Thus, a cost-benefit ratio of 1.07 indicates that there is a potential gain of $1.00 to society due to a reduction in burn injuries and deaths for every $1.07 spent on flame retardant sleepwear. In the case of clothing, relaxation of the assumption of perfectly elastic supply has a relatively minor impact on the cost-benefit ratios. The most conservative cost estimate, in which supply is assumed to be perfectly elastic, is thus unlikely to result in much underestimation of cost-benefit ratios if the underlying elasticity values are close to unity.

TABLE 3

COST-BENEFIT RATIOS FOR FLAMMABILITY STANDARDS FOR CLOTHING AND SLEEPWEAR

The most interesting result is the different cost-benefit ratios for clothing and sleepwear. Cost-benefit ratios for clothing range from eleven to twelve compared to cost-benefit ratios in the neighborhood of one for sleepwear. These results may explain the decision of the Consumer Product Safety Commission to develop a mandatory standard for children's sleepwear while delaying the introduction of a mandatory standard for children's clothing. The different cost-benefit ratios for the two merchandise categories also indicate a major problem facing a regulatory agency which seeks to increase the scope of its activities. When the scope of mandatory standards is increased, the cost to the consumer may also increase without a commensurate increase in benefits if the target population is expanded to include "low-risk" groups. Thus, while it may be more efficient from an engineering and regulatory perspective to issue generic standards, e.g., a general wearing apparel standard, it may also be cost-ineffective.

The cost-benefit ratios obtained in this study are based on the assumption that 100% of the potential benefits could be realized, i.e., that the flammability standards would provide 100% protection from burn injuries and deaths. Justification for this assumption in the case of sleepwear is based on consultation with major retailers and insurance companies in which it was pointed out that the children's sleepwear standard appears to have been relatively effective in reducing serious burn injuries and deaths. One reason may be the relative unimportance of flammable liquids in the case of sleepwear ignition. However, flammability standards for clothing may be more limited in their effectiveness since flammable liquids are more likely to be involved. Thus, the potential benefits from flammability standards for children's clothing are likely to be over-estimated.

CONCLUSION

Several limitations of the analysis must be borne in mind in evaluating the results of this study. Cost estimates were based on the assumption of unchanged product quality (other than safety) so that no allowance was made for the reduction in consumer choice. Underestimation of benefits also occurred since no allowance was made for pain and suffering. The value of a livelihood approach which was employed in this study will also have resulted in an underestimation of potential benefits if the value an individual attaches to his life is greater than the present value of future earnings.

Notwithstanding these limitations, cost-benefit analysis may be viewed as making a significant contribution to consumer protection programs in two major areas. First, cost-benefit analysis serves as a decision-making tool which makes explicit the costs and benefits of a particular safety program. Second, it serves as a basis for program comparisons. The cost-benefit ratio for a particular safety program is less important than its relationship to cost-benefit ratios for alternative programs.

The results of this study indicate that the 7-14 Children's Sleepwear Standard is cost-effective in contrast to the hypothetical 7-14 Children's Clothing Standard where high cost-benefit ratios exist. In this instance the employment of a specific rather than a generic standard appears to have been the most appropriate consumer protection program.

REFERENCES

Consumer Product Safety Commission, Reports Required by the Flammable Fabrics Act, 1974.

I. Feller, "Introduction to the Burned Patient Problem in the United States of America," Proceedings, Third Annual Meeting of the Information Council on Fabric Flammability, New York City, December, 1969.

A. Harberger, "Three Basic Postulates for Applied Welfare Economics: An Interpretative Essay", Journal of Econ. Literature, 9, (1971), 785-797.

E. J. Mishan, Cost-Benefit Analysis (New York: Praeger Publishers, 1971).

National Commission on Product Safety, Final Report, June 1970.

National Fire Protection Association, "The Single-Fatality Fire", Fire Journal, 63 (1969), 34-35.

L. J. Sharman, H. Tovey and A. K. Vickers, "Current Status and National Priorities for Flammable Fabric Standards,'' Proceedings, Sixth Annual Meeting of the Information Council on Fabric Flammability, New York City, December, 1972.

U. S. Department of Health, Education and Welfare, Flammable Fabrics, Second Annual Report, 1970.

U. S. Department of Health, Education and Welfare, Flammable Fabrics, Third Annual Report, 1971.

U. S. Department of Health, Education and Welfare, Flammable Fabrics, Fourth Annual Report, 1972.

J. F. Weston, "Economic Aspects of Consumer Product Safety Standards", in National Commission on Product Safety, Hearings, Washington, D. C., March 4, 1970.

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