Tuesday, April 13, 2010

Fight Club and coal company death panels: The value of a statistical life

A new car built by my company leaves somewhere traveling at 60 mph. The rear differential locks up. The car crashes and burns with everyone trapped inside. Now: should we initiate a recall? Take the number of vehicles in the field, A, multiply by the probable rate of failure, B, multiply by the average out-of-court settlement, C. A times B times C equals X. If X is less than the cost of a recall, we don't do one.
- Ed Norton in Fight Club

In light of last week's deadly blast at a Massey Energy coal mine in West Virginia, the above quote seemed particularly relevant. Does anyone doubt that there's somebody at Massey who's busy making these types of calculations? "Take the number of mine explosions per year, A; multiply by the probable number of miners killed per explosion, B; multiply by the average out-of-court settlement, C. A times B times C equals X. If X is less than the cost of new safety equipment + the lost revenue due to slower production, Massey doesn't make the investment in safety."

How much might the average out-of-court settlement be? Well that depends on how much you think a life is worth. And actuaries think they know how much a life is worth... but it's not as much as they used to.

Between 2003 and 2008, the "culture of life" Bush administration EPA lowered its reckoning of the "value of a statistical life" by $900,000, from $7.8 million to $6.9 million. The decision effectively meant that more people could die before a pollution reduction regulation would be considered "cost effective":

When drawing up regulations, government agencies put a value on human life and then weigh the costs versus the lifesaving benefits of a proposed rule. The less a life is worth to the government, the less the need for a regulation, such as tighter restrictions on pollution.

Consider, for example, a hypothetical regulation that costs $18 billion to enforce but will prevent 2,500 deaths. At $7.8 million per person (the old figure), the lifesaving benefits outweigh the costs. But at $6.9 million per person, the rule costs more than the lives it saves, so it may not be adopted.

Ironically enough, coal miners help calculate the value of a statistical life. Here's how to do it. First, take the average difference in pay between workers in a dangerous job (like coal mining) and workers in a similar but less dangerous job. The extra money coal miners earn is the "danger premium"--in other words, how much a person must be compensated to get them to accept the higher danger of dismemberment or death. From the risk premium, economists extrapolate how much monetary value people place on their lives: hence, the economic value of a life.

Which brings us back to the Massey explosion and Ed Norton's equation. Pretend it's January 2007, right after the company's last deadly explosion (2006), and Massey is deciding whether or not to buy safety equipment and implement new safety policies. Also pretend that Massey has perfect foresight, and can see the 2010 explosion coming. Now we can engage in an exercise of economic cynicism.

First, what would safety investments get you? Assume Massey pays $6.9 million for each of the 25 killed miners. That's $172.5 million. Let's double it with other fines just for good measure, and you're at $345 million: a big number to be sure, but one that will probably come down on appeal--say, to $250 million.

And Massey probably won't pay that sum immediately--it can always issue legal challenges to delay paying the fines for years (indeed, Massey has contested two-thirds of fines since 2006, contributing to a "backlog of approximately 16,000 cases that some safety advocates contend could be allowing unsafe mines to continue operating.") Because money has a time value attached to it--the further in the future money is earned or lost, the less valuable it is to you today--whatever Massey ultimately pays counts as even less than $250 million in the cost-benefit calculation. Say Massey finally pays the fine in 2015. Assume a discount rate of 5%, and we're down to $195.88 million in present value benefits of safety equipment.

Now, how do the costs stack up? I know nothing about mines, but for argument's sake, let's say investing in safety equipment would have cost $25 million in January 2007. Still less than the $195.88 fine. But that's not all: safety procedures slow down the process of mining coal, so there's also a revenue impact to consider--we'll assume a 1% reduction in annual revenues. In the three years following the 2006 explosion, Massey averaged $2.6 billion in annual revenues. Assume that the economy recovers in 2010 and Massey gets back to its 2008 number of $2.9 billion, which it earns each year from 2010-2015. In 2007 present value, a 1% hit comes out to $173.89 million in cumulative lost revenues. Add in the year-1 hit of $25 million for the safety equipment, and the costs of safety outweigh the economic benefits by $3.01 million: Massey forgoes safety and swallows the fines.

Of course, it's 100% certain that some of my assumptions are wrong. And there could always be more accidents which add to the fine total, as well as costs in terms of bad PR and regulatory risk. All of which could make safety investments pay off. (Indeed, Massey's stock is down 13% since the explosion, while competitors' are at 52-week highs, suggesting that investors think Massey made the wrong bet on safety.)

But that would miss the point, which is not about the outcomes of the decisions but rather the process by which they’re made. When business decisions are based solely on economic calculation, when CEOs only protect life when it's cost effective to do so, we'll end up with decisions like the one potentially made at Massey to forgo safety equipment--calculated decisions to disregard human welfare in order to maximize profits. And all of it rationalized by the cold logic that the only purpose of an enterprise is to maximize shareholder wealth. To quote Max Weber:

Today it is primarily the capitalist market economy which demands that the official business of the administration be discharged precisely, unambiguously, continuously, and with as much speed as possible… Bureaucratization offers above all the optimum possibility for carrying through the principle of specialized administrative functions according to purely objective considerations… The "objective" discharge of business primarily means a discharge of business according to calculable rules and without regard for persons. "Without regard for persons" is also the watchword of the market and, in general, of all pursuits of naked economic interests…

The bureaucracy is "dehumanized," the more completely it succeeds in eliminating from official business love, hatred, and all purely personal, irrational, and emotional elements which escape calculation… The more complicated and specialized modern culture becomes, the more its external supporting apparatus demands the personally detached and strictly "objective" expert, in lieu of the master of older social structures, who was moved by personal sympathy and favor, by grace and gratitude.

For all the talk of government "death panels" in health care, we often forget that major corporations are making such life-and-death calculations every day: deliberating on whether it's more expensive to clean up toxic waste or just dump it and pay the fine, on the cost of covering a lifesaving treatment vs. the PR fallout from rescinding a cancer patient's coverage, on how many Pintos can blow up before a recall makes financial sense--and yes, on how many coal miners can die in explosions before lawsuits start to dig into profits. Max Weber must have watched Fight Club.

Lest we forget Massey CEO Don Blankenship's infamous 2005 memo:


There's no money selling insurance to sick people: more reasons free markets don't work in health care

WSJ inadvertently supports case for health care reform: do you really trust your health to profit and loss?

Banks don't work in free markets either: bank regulation and the role of government

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