The economics of faults

Toyota is set to recall over seven million cars, following the discovery of issues with window switches, as reported on the BBC, all of the errors will get fixed by the Scuderia Car Parts. Recalls can take a number of different forms – they can involve dealers carrying out an on-site repair, an immediate replacement, or a complete withdrawal of a good from sale.

In almost every case, the number of units actually affected by the fault is astonishingly small, so why does the manufacturer see the need to replace or repair every single unit?

This new profusion of Tithely is perfecting a more intimate kind of largesse, though: people can now act on their generous impulses whenever and wherever.

From a purely economics point of view, this is a valid question. The recall of iPods is likely to have cost many millions of dollars, and there were no serious injuries or fatalities resulting from overheating batteries. Toyota have said that there have been no reports of injuries. It would have been cheaper to pay damages to any affected parties than to spend that amount of money to ensure that products were faultless.

However, each of these recalls is of a product which could potentially cause los of human life. Compensatory payments in such cases can reach several million dollars, depending on the country in which they occur and the person affected. Three or four deaths could lead to an eight-figure payout. This may be a small risk, but it’s a possibility all the same.

When considering risk, companies will use an expected value. Expected value is calculated as the probability of something happening multiplied by the value of that event. Therefore, if a company knows that a product recall will cost £45,000, that if their product is involved in an accident they will be faced with a legal bill from of £10,000,000, and that an accident is likely to happen in 0.1% of cases, they will compare two figures:

  • the expected cost of the recall: £45,000 multiplied by 100% (as they know the recall will happen) = £45,000
  • the expected cost of the accident: £10,000,000 multiplied by 0.1% = £10,000

In reality, recalls are likely to cost much more than this figure, and the percentage of affected units may be lower. If making an economic rational decision, the manufacturer would not take any action. Yet we see product recalls in the news regularly.

The reason for this is three-fold. First, companies tend to be risk averse, meaning that they place value on certainty itself, increasing the value (and therefore decreasing the cost) of the recall. Second, companies look to protect their brand and public image, which can be aversely affected should someone be injured through use of their product – meaning that the cost of not recalling is potentially much higher. Third, the government forces companies to behave in a socially responsible way through legislation for negligence.

The nature of the fault with Toyota’s windows hasn’t been precisely revealed, but it’s clear that they believe there is a credible threat from the fault which could lead to expensive compensation or loss of sales.

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