The Precautionary Principle is the widely held notion that uncertainty about risk ought not be used as a barrier to making decisions to reduce or avoid it. Extended warranties for consumer products provide a real-world example how the Precautionary Principle can be found in otherwise very ordinary market transactions. A recent article in the Washington Post illuminates why.
THE PRECAUTIONARY PRINCIPLE
The Precautionary Principle has many definitions, but they share two general themes. First, uncertainty about either the existence or magnitude of risk should not be a barrier to regulatory decisionmaking. Second, those who believe a substance, technology or activity is safe should bear the burden of proof rather than those who believe it may be risky.
The Precautionary Principle has its advocates among both activists and scholars. For example, David Kreibel and Joel Tickner praise the 1999 decision by the Los Angeles Unified School District to adopt “nonchemical approaches to pest control.” The school district’s policy reads in part:
The “Precautionary Principle”, the long-term objective of the District, recognizes that no pesticide product is free from risk or threat to human health, and industrial producers should be required to prove that their pesticide products demonstrate an absence of risk, rather than requiring that the government or the public prove that human health is being harmed.
If applied literally, the “proof of safety” component of this policy would prevent the use of all chemical pesticides, because the absence of risk can never be proved. However, the LA Unified School District has published a list of pesticides approved for use. How the school district actually makes decisions is not clear from the available policy documents. What is clear is that the school district focuses almost solely on potential hazard and almost not at all on exposure.
The Precautionary Principle also has its detractors. Former OIRA Administrator John Graham contests the assumption that science generally reveals hazards to be greater than expected. He cites saccharin, electric power lines, silicone breast implants, cell phones, and endocrine disruption as examples where science has not supported the risk estimates that gave rise to precautionary decisionmaking. (He provides particulate matter as a counter example where science suggests risks are greater than initially perceived.) Graham says that if the Precautionary Principle had been in place in 1850, electricity, the internal combustion engine, plastics, pharmaceuticals, the Internet, and cell phones, among other things, would not have been developed. He also disputes the notion that Europe is generally precautionary whereas the United States is not:
Some have argued that the USA is more tolerant than Europe of the possible risks of bioengineered foods, global climate change and industrial chemical exposures. However, a fair analysis would also show that Europe has been less precautionary than the USA on diesel engine exhaust, environmental tobacco smoke, and lead in gasoline.
Finally, there are others who say the Precautionary Principle is not applied consistently by its advocates. Bernard Goldstein says the Precautionary Principle may be a sensible approach to public health but that public health advocates “are sometimes guilty of not adhering to this principle.” Goldstein’s position is that “the precautionary principle needs to be applied to public health actions as well as to actions pursued by government and industry for competitive and economic reasons.” Jonathan Wiener has argued here and here that the US’ decision to invade Iraq can be justified by the Precautionary Principle given uncertainty about the presence of weapons of mass destruction. He appears to find it ironic that much of Europe has been unwilling to apply the Precautionary Principle to military decisionmaking. He says “the terrorism example illustrates that the new U.S. doctrine of preemptive self-defense is based on the same logic as the precautionary principle,” which European leaders (especially Greens) make with respect to environmental protection (especially global climate change).
Depending on how it is defined, the Precautionary Principle can be entirely consistent with net-benefit maximizing behavior of the type economists consider rational. Precautionary decisionmaking is how people implement risk aversion, a well-known and empirically confirmed phenomenon. The Precautionary Principle is hard to reconcile with economic theory and evidence when it leads policies that do not maximize net benefits — that is, when a decision is so precautionary that it yields greater costs than benefits even to its intended beneficiaries.
INSURANCE AND EXTENDED WARRANTIES
Insurance is perhaps the best example of a product routinely sold in the marketplace for which the Precautionary Principle is the dominant reason why the market exists. Insurers bet that the insured-against event will not occur, but buyers of insurance bet that it will. Sellers often have much better information than buyers concerning the likelihood and magnitude of covered losses. This asymmetry in information can leave buyers at a disadvantage, but as long as sellers compete for business much of the potential value of special knowledge will be competed away.
Buyers of insurance have advantages, too. They know more about their own conditions and circumstances, leading to the problem of adverse selection in which those who know they are bad risks are more prone to buy. Insurers have to probe carefully to get insureds to reveal this information, but low-risk insureds have powerful incentives to reveal it voluntarily so as to get a better deal that high-risk insureds. Simply having insurance induces people to be less careful, a problem called moral hazard.
These are normal phenomena in nearly all insurance markets. There is nothing special about extended warranties as a class that would justify concluding that they are per se bad investments in precaution. Yet seemingly everyone from consumer activists to professional economists say these insurance contracts are bad investments and people almost never should buy them. Like all other insurance contracts, whether extended warranties are good for consumers depends on what’s covered and what it costs.
For the uninitiated, these products are insurance contracts that protect purchasers from certain specified losses if a product fails after the manufacturer’s warranty expires. A long article by Washington Post reporter Terence O’Hara reiterates what all the experts “know:”
Each year, millions of people gladly pay an additional 10 to 50 percent of a product’s original price to extend a warranty. These snap purchases help fuel a booming, $15 billion-a-year business and feed a lucrative profit stream for retailers that sell the warranties and companies that underwrite them. Many consumers do so because they say the plans provide them with peace of mind.
The decision to buy an extended warranty, however, defies the recommendations of economists, consumer advocates and product quality experts, who all warn that the plans rarely benefit consumers and are nearly always a waste of money.
“The things make no rational sense,” Harvard economist David Cutler said. “The implied probability that [a product] will break has to be substantially greater than the risk that you can’t afford to fix it or replace it. If you’re buying a $400 item, for the overwhelming number of consumers that level of spending is not a risk you need to insure under any circumstances.”
Are consumers who buy extended warranties irrational, as Cutler says, or are they applying the Precautionary Principle? And if they are following a precautionary decision rule, are they doing so rationally (i.e., the warranty offers net benefits) or irrationally (i.e., the warranty imposes net costs)?
O’Hara’s story says that in almost all cases, extended warranties impose net costs. But this is an empirical question that cannot be addressed without data about both insurance coverage and cost — data that neither O’Hara nor the critics she cites disclose. Extending a warranty always has positive value; the only question is whether this positive value is more or less than the cost of the warranty. If it’s greater than the cost, then purchasing the extended warranty is clearly rational. Only if the value of the extended warranty is less than its cost is there a potential case that purchasing the extended warranty is irrational. (We say potential because extended warranties, like other forms of insurance, also provide the intangible benefit of peace of mind. Many regulatory actions are defended on the ground that they confer intangible benefits that cannot be readily monetized. If the intangible benefit of peace of mind from insurance is to be dismissed as irrelevant or insignificant, then the same must be be done with respect to the analogous intangible benefits from regulation. We would concede that the purchase of an extended warranty is irrational if intangible benefits from peace of mind must be extraordinary for the warranty to confer net benefits.)
EXTENDED WARRANTIES ARE IRRATIONAL IN THE SAME WAY THE PRECAUTIONARY PRINCIPLE IS IRRATIONAL
Extended warranties could impose net costs if sellers exaggerate the likelihood of product failure or the cost of repair. But this is not evidence of irrational decisionmaking by consumers; it’s evidence of misinformed decisionmaking When sellers mislead buyers to consummate a sale, they are committing fraud. That’s true whether the sale concerns an extended warranty or the product being warranted.
But the problem of misinformed decisionmaking occurs in the public arena as well. Like some sellers of extended warranties, some stakeholders prey on fears of the unknown and unknowable in order to motivate decisions to be made based on the Precautionary Principle. That doesn’t mean the Precautionary Principle is always wrong any more than it means extended warranties are always foolish.
The adage that an ounce of prevention is worth a pound of cure is correct as long as the relative price of prevention is less than 1/16th of the price of cures.