Economics Of Safety Research Paper

1. ‘ Pure ’ Neoclassical Economics

The neoclassical theory of work injuries is examined in Thomason and Burton (1993). Workplace accidents are undesirable by-products of processes that produce goods for consumption (Oi 1974). Several assumptions are used in the neoclassical analysis of these processes. Employers and workers have an ongoing relationship. Employers maximize profits. Workers maximize utility, not just pecuniary income. Workers at the margin are mobile and possess accurate information concerning the risks and consequences of work injuries. One implication of these assumptions is that employers pay higher wages for hazardous work than for nonhazardous work. On the assumption that accident insurance is not provided by employers or the government, the equilibrium wage for the hazardous work will include a risk premium equal to the expected costs of the injuries, which includes lost wages, medical care, and the disutility caused by the injury. If workers are risk averse, the premium will also include a payment for the uncertainty about who will be injured.

The employer has an incentive to invest in safety in order to reduce accidents and thus the risk premium. The firm will make safety investments until the marginal expenditure on safety is equal to the marginal reduction in the risk premium. Since there is a rising marginal cost to investments in safety, equilibrium will occur with a positive value for the risk premium, which means that in equilibrium there will be some work injuries.

Variants on neoclassical economics theory can be generated by changing some of the previous assumptions. For example, if all workers purchase actuarially fair insurance covering the full costs of work injuries, they will be indifferent about being injured. Furthermore, if injured, workers will have no incentive to return to work since the insurance fully compensates them for their economic losses. The change in worker behavior resulting from the availability of insurance is an example of the moral hazard problem, in which the insurance increases the quantity of the events being insured against (i.e., the occurrence of injuries and the durations of the resulting disabilities). These variants on neoclassical economics with their implications for employee behavior are discussed in Burton and Chelius (1997).

1.1 Evidence Consistent With The Neoclassical Model

There is a burgeoning literature on compensating wage differentials for the risks of workplace death and injury. Ehrenberg and Smith (1996) report that generally studies find industries having the average risk of job fatalities (about 1 per 10,000 workers per year) pay wages that are 0.5 percent to 2 percent higher than the wages for comparable workers in industries with half that level of risk. Viscusi (1993) reviewed 17 studies estimating wage premiums for the risks of job injuries, and 24 studies estimating premiums for the risks of job fatalities. The total amount of risk premiums implied by these various estimates is substantial: probably the upper bound is the Kniesner and Leeth (1995) figure of $200 billion in risk premiums in the US in 1993.

The Viscusi (1993) survey of studies of risk premiums for workplace fatalities included evidence from the United Kingdom (UK), Quebec, Japan, and Australia. More recently, Siebert and Wie (1994) found evidence for risk premiums for work injuries in the UK, and Miller et al. (1997) provided additional evidence on compensating differentials for risk of death in Australia.

1.2 Qualifications Concerning The Neoclassical Theory

The model that postulates workplace safety results from risk premiums that provide financial incentives to employers to invest in safety has been challenged. Some critics assert that risk premiums are inadequate because workers lack sufficient information about the risks of work injuries and/or have limited mobility to move to less hazardous jobs. Ehrenberg and Smith (1996) conclude that workers have enough knowledge to form accurate judgments about the relative risks of various jobs. However, Viscusi (1993) refers to a sizable literature in psychology and economics documenting that individuals tend to overestimate low probability events, such as workplace injuries, which could result in inappropriately large risk premiums. Both Ehrenberg and Smith (1996) and Viscusi (1993) argue there is sufficient worker mobility to generate risk premiums. Another challenger to the neoclassical model is Ackerman (1988), who argues that the labor market does not generate proper risk premiums because certain costs resulting from work injuries are not borne by workers but are externalized.

The empirical evidence on risk premiums has also been challenged or qualified. Ehrenberg and Smith (1996), for example, conclude that the studies of compensating wage differentials for the risks of injury or death on the job ‘ are generally, but not completely, supportive of the theory. ’ Viscusi (1993) concludes: ‘ The wage-risk relationship is not as robust as is, for example, the effect of education on wages. ’

The most telling attack on the compensating wage differential evidence is by Dorman and Hagstrom (1998), who argue that most studies have been specified improperly. They find that, after controlling for industry-level factors, the only evidence for positive compensating wage differential pertains to unionized workers. For nonunion workers, they argue that properly specified regressions suggest that workers in dangerous jobs are likely to be paid less than equivalent workers in safer jobs.

The Dorman and Hagstrom challenge to the previously generally accepted view—that dangerous work results in risks premiums for most workers—is likely to result in new empirical studies attempting to resuscitate the notion of risk premiums. However, even if every empirical study finds a risk premium for workplace fatalities and injuries, the evidence would not conclusively validate the neoclassical economics approach. Ehrenberg (1988) provides the necessary qualification: if there are any market imperfections (such as lack of information or mobility), the ‘ mere existence of some wage differential does not imply that it is a fully compensating one. ’ And if the risk premium is not fully compensating (or is more than fully compensating), then inter alia, the market does not provide the proper incentive to employers to invest in safety.

Another qualification concerning the use of risk premiums as a stimulus to safety is that institutional features in a country ’s labor market may aid or impede the generation of risk premiums. In the US, the relative lack of government regulation of the labor market and the relative weakness of unions probably facilitate the generation of risk premiums. In countries like Germany, where unions are relatively strong and apparently opposed to wage premiums for risks, and where labor markets appear to be less flexible than those in the US because of government regulation of the labor market, wages are less likely to reflect underlying market forces that produce risk premiums.

2. Modified Neoclassical Economics And The Old Institutional Economics

Some economists rely on a ‘ modified ’ version of neoclassical economics theory that recognizes limited types of government regulation of safety and health are appropriate in order to overcome some of the attributes of the labor market that do not correspond to the assumptions of pure neoclassical economics. These attributes include the lack of sufficient knowledge and mobility by employees, and the possible lack of sufficient knowledge or motivation of employers about the relationship between expenditures on safety and the reduction in risk premiums. The ‘ old institutional economists ’ (OIE) would agree with these critiques of lack of knowledge and mobility, and would also emphasize factors such as the unequal bargaining power of individual workers as another limitation of the labor market.

An example of government promulgation of information in order to overcome the lack of knowledge in the labor market is the Occupational Safety and Health Act (OSHAct) Hazard Communication standard, which requires labeling of hazardous substances and notification to workers and customers and which is estimated to save 200 lives per year (Viscusi 1996). (Other aspects of the OSHAct are discussed below.)

2.1 Experience Rating

An example of a labor market intervention that could improve incentives for employers to invest in safety is the use of experience rating in workers ’ compensation programs, which provide medical and cash benefits to workers injured at work. Firm-level experience rating is used extensively in the workers ’ compensation programs in the US, and is used to some degree in many other countries, including Canada, France, and Germany. Firm-level experience rating determines the workers ’ compensation premium for each firm above a minimum size by comparing its prior benefit payments to those of other firms in the industry.

In the pure neoclassical economics model, the introduction of workers ’ compensation with experience rating should make no difference in the safety incentives for employers compared to the incentives provided by the labor market without workers ’ compensation. Under assumptions such as perfect experience rating, risk neutrality by workers, and actuarially fair workers ’ compensation premiums, which are explicated by Burton and Chelius (1997), the risk premium portion of the wage paid by the employer will be reduced by an amount exactly equal to the amount of the workers ’ compensation premium. Also, under these assumptions, the employer has the same economic incentives to invest in safety both before and after the introduction of the workers ’ compensation program. Under an alternative variant of the pure neoclassical economics approach, in which the assumption of perfect experience rating is dropped, the introduction of workers ’ compensation will result in reduced incentives for employers to reduce accidents.

In contrast, the OIE approach argues that the introduction of workers ’ compensation with experience rating should improve safety because the limitations of knowledge and mobility and the unequal bargaining power for employees mean that the risk premiums generated in the labor market are inadequate to provide employers the safety incentives postulated by the pure neoclassical economics approach. Commons (1934), a leading figure in the OIE approached, claimed that unemployment is the leading cause of labor market problems, including injuries and fatalities, because slack labor markets undercut the mechanism that generates compensating wage differentials. Commons asserted that experience rating provides employers economic incentives to get the ‘ safety spirit ’ that would otherwise be lacking. The modified neoclassical economics approach also accepts the idea that experience rating should help improve safety by providing stronger incentives to employers to avoid accidents, although they place less emphasis on the role of unemployment in undercutting compensating wage differentials and more emphasis on the failure of employers to recognize the cost savings possible from improved safety without the clear signals provided by experience-rated premiums.

A number of recent studies of the workers ’ compensation program provide evidence that should help assess the virtues of the various economic theories. However, the evidence from US studies is inconclusive. One survey of studies of experience rating by Boden (1995) concluded that ‘ research on the safety impacts has not provided a clear answer to whether workers ’ compensation improves workplace safety. ’ In contrast, a recent survey by Butler (1994) found that most recent studies provide statistically significant evidence that experience rating ‘ has had at least some role in improving workplace safety for large firms. ’ Burton and Chelius (1997) sided with Butler. The beneficial effect of experience rating on safety has been found in Canada by Bruce and Atkins (1993) and in France by Aiuppa and Trieschmann (1998).

The mildly persuasive evidence that experience rating improves safety is consistent with the positive impact on safety postulated by the OIE approach and the modified neoclassical economists, and is inconsistent with the pure neoclassical view that the use of experience rating should be irrelevant or may even lead to reduced incentives for employers to improve workplace safety.

2.2 Collective Action

While the modified neoclassical economists and the OIE largely would agree on the desirability of several prevention approaches, such as the use of experience rating in workers ’ compensation, the OIE endorsed another approach that many modified neoclassical economists would not support, namely the use of collective bargaining and other policies that empower workers. Collective bargaining agreements can minimize unsafe activities or at least explicitly require employers to pay a wage premium for unsafe work. Many agreements also establish safety committees that assume responsibility for certain activities, such as participation in inspections conducted by government officials. If workers are injured, unions can help them obtain workers ’ compensation benefits, thereby increasing the financial incentives for employers to improve workplace safety.

The beneficial effects predicted by the OIE approach for these collective efforts appear to be achieved. Several studies, including Weil (1999) concluded that OSHA enforcement activity was greater in unionized firms than in nonunionized firms. Moore and Viscusi (1990) and other researchers found that unionized workers receive larger compensating wage differentials for job risks than unorganized workers. Hirsch et al. (1997) found that ‘ unionized workers were substantially more likely to receive workers ’ compensation benefits than were similar nonunion workers. ’ Experience rating means that these higher benefit payments will provide greater economic incentives for these unionized employers to reduce injuries.

There are also safety committees in some jurisdictions that are utilized in nonunionized firms. Burton and Chelius (1997) reviewed several studies involving such committees in the US and Canada, and found limited empirical support for their beneficial effects. Reilly et al. (1995) provided a more positive assessment for their accomplishments in the UK. These studies provide some additional support for the beneficial role of collective action postulated by the OIE.

3. The New Institutional Economics

New institutional economics (NIE) authors generally argue that market forces encourage efficient forms of economic organization without government assistance and that opportunities for efficiency-improving public interventions are rare. This section considers only the Coase theory/transaction costs economics strain of NIE.

3.1 The Coase Theory And Transaction Costs Economics

In the absence of costs involved in carrying out market transactions, changing the legal rules about who is liable for damages resulting from an accident will not affect decisions involving expenditures of resources that increase the combined wealth of the parties. The classic example offered by Coase (1988) involves the case of straying cattle that can destroy crops growing on neighboring land. The parties will negotiate the best solution to the size of the herd, the construction of a fence, and the amount of crop loss due to the cattle whether or not the cattle-rancher is assigned liability for the crop damages.

Coase recognized that the assumption that there were no costs involved in carrying out transactions was ‘ very unrealistic. ’ According to Coase (1988):

In order to carry out a market transaction, it is necessary to discover who it is that one wishes to deal with … and on what terms, to conduct negotiations …, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often … sufficiently costly … to prevent many transactions that would be carried out in a world in which the pricing system worked without cost.

The goal of transactions costs economics is to examine these costs and to determine their effect on the operation of the economy. As scholars of transaction costs have demonstrated, when transactions costs are significant, changing the legal rules about initial liability can affect the allocation of resources.

3.2 Evidence Concerning Changes In Liability Rules

Workplace safety regulation provides a good example of a change in liability rules, since in a relatively short period (1910–20), most US states replaced tort suits (the employer was only responsible for damages if negligent) with workers ’ compensation (the employer is required to provide benefits under a no-fault rule) as the basic remedy for workplace injuries. Evidence from Chelius (1977) ‘ clearly indicated that the death rate declined after workers ’ compensation was instituted as the remedy for accident costs. ’ This result suggests that high transaction costs associated with the determination of fault in negligence suits were an obstacle to achieving the proper incentives to workplace safety, and that the institutional features of workers ’ compensation, including the no-fault principle and experience rating, provided a relatively more efficient approach to the prevention of work injuries.

An interesting study that also suggests that institutional features can play a major role in determining the effects of changing liability rules is Fishback (1987). He found that fatality rates in coal mining were generally higher after states replaced negligence law with workers ’ compensation. Fishback suggested that the difference between his general results and those of Chelius might be due to high supervision costs in coal mining in the early 1900s.

The transaction economics component of the NIE theory thus appears to provide a useful supplement to neoclassical economics, since institutional features, such as liability rules, can have a major impact on the economic incentives for accident prevention.

4. Law And Economics

Law and economics (L&E) theory draws on neoclassical economics and transaction cost economics, but is distinctive in the extent to which it examines legal institutions and legal problems. This section examines the tort law branch of L&E theory, while the next section examines the employment law branch.

4.1 Theoretical Stimulus Of Tort Law To Safety

Tort law typically is used when one party harms another party, and the parties do not have an ongoing relationship. However, even though workers and employers have a continuing relationship, tort suits were generally used as a remedy for workplace accidents in the US until workers ’ compensation programs were established. When negligence is the legal standard used for tort suits, if the employer has not taken proper measures to prevent accidents and thus is at fault, the employer will be liable for all of the consequences of the injury. The standard for the proper prevention measure was developed by Judge Learned Hand and restated by Posner (1972) as:

The judge (or jury) should attempt to measure three things in ascertaining negligence: the magnitude of the loss if an accident occurs; the probability of the accident ’s occurring; and the burden (cost) of taking precautions to prevent it. If the product of the first two terms, the expected benefits, exceeds the burden of precautions, the failure to take those precautions is negligence.

Posner argued that proper application of this standard would result in economically efficient incentives to avoid accidents. Burton and Chelius (1977) examine some qualifications to this conclusion.

4.2 Evidence On The Tort Law Stimulus To Safety

There are two types of empirical evidence that suggest skepticism is warranted about the stimulus to workplace safety from tort suits. First, tort suits were used as the remedy for workplace injuries in the late 1800s and early 1900s. As previously noted, Chelius (1977) found that the replacement of the negligence remedy with workers ’ compensation led to a general reduction in workplace fatalities. The Fishback (1987) contrary result for a specific industry—coal mining—provides a qualification to this general result.

Second, in other areas of tort law, there is a major controversy among legal scholars about whether the theoretical incentives for safety resulting from tort suits actually work. One school of thought is exemplified by Landes and Posner (1987), who state that ‘ although there has been little systematic study of the deterrent effect of tort law, what empirical evidence there is indicates that tort law … deters. ’ An opposing view of the deterrent effects of tort law is provided by Priest (1991), who finds almost no relationship between actual liability payouts and the accident rate for general aviation and states that ‘ this relationship between liability payouts and accidents appears typical of other areas of modern tort law as well, such as medical malpractice and product liability. ’

A study of tort law by Schwartz (1994) distinguished a strong form of deterrence (as postulated by Landes and Posner) from a moderate form of deterrence, in which ‘ tort law provides a significant amount of deterrence, yet considerably less that the economists ’ formulae tend to predict. ’ Schwartz surveyed a variety of areas where tort law is used, including motorist liability, medical malpractice, and product liability, and concluded that that the evidence undermines the strong form of deterrence but provides adequate support for the moderate form of deterrence. As to workers ’ injuries, Schwartz cited the Chelius and Fishback studies and concluded ‘ it is unclear whether a tort system or workers ’ compensation provides better incentives for workplace safety. ’ Burton and Chelius (1997) concluded, based on both the ambiguous historical experience of the impact of workers ’ compensation on workplace safety and the current controversy over the deterrence effect in other areas of tort law, that ‘ the law and economics theory concerning tort law does not provide much assistance in designing an optimal policy for workplace safety and health. ’

Further examinations of the relative merits of workers ’ compensation and the tort system in dealing with workplace accidents are Dewees et al. (1996) and Thomason et al. (1998).

5. Government Mandate Theory Vs. Law And Economics Theory

5.1 The Government Mandate Theory

The government mandate theory argues that the government promulgation of health and safety standards and enforcement of the standards by inspections and fines will improve workplace safety and health. This is basically a legal theory, although many of the supporting arguments involve reinterpretation or rejection of studies conducted by economists. For example, proponents of the theory object to the evidence on compensating wage differentials and on the deterrent effect of experience rating and object in principle to economists ’ reliance on cost-benefit analysis. Supporters of the theory, such as McGarity and Shapiro (1996), also provide a positive case why OSHA is necessary:

OSHA ’s capacity to write safety and health regulations is not bounded by any individual worker ’s limited financial resources. Likewise, OSHA ’s capacity to stimulate an employer to action does not depend upon the employees ’ knowledge of occupation risks or bargaining power.

The government mandate theory would not be endorsed by many economists, including the OIE. Commons and Andrews (1936), for example, criticized at length the punitive approaches that used factory inspectors in the form of policemen, since this turned employers into adversaries with the law. The minimum standards supported by the OIE were those developed by a tripartite commission, involving employers, employees, and the public, rather than standards promulgated by the government. While the OIE theory is, thus, unsympathetic to the government mandate theory, the sharpest attack is derived from the L&E theory.

5.2 The L&E Theory Concerning Government Regulations

L&E scholars make a distinction between mandatory, minimum terms (standards) and those terms that are merely default provisions (or guidelines) that employers and employees can agree to override. Most employment laws, including workplace safety laws, create standards and are thus objectionable to the L&E scholars.

Willborn (1988) articulated the standard economic objections to mandatory terms. Employers will treat newly imposed standards like exogenous wage increases and in the short run will respond by laying off workers. In the long run, employers will try to respond to mandates by lowering the wage. The final wagebenefits-standards employment package will make workers worse off than they were before the imposition of standards—otherwise the employers and workers would have bargaining for the package without legal compulsion.

5.3 Evidence On The Effects Of OSHA Standards

The evidence, as reviewed by Burton and Chelius (1997), suggests that the OSHAct has done little to improve workplace safety, thus lending more support to the L&E theory than to the government mandate theory. OSHA ’s ineffectiveness in part may be due to the lack of inspection activity, since the average establishment is only inspected once every 84 years. But the evidence also suggests that allocating additional resources to plant inspections may be imprudent. Smith (1992) concluded, after an exhaustive review of the studies of OSHA inspections, that the evidence ‘ suggests that inspections reduce injuries by 2 percent to 15 percent, ’ although the estimates often are not statistically significant (and thus cannot be distinguished confidently from zero effect).

Several studies, including Scholz and Gray (1990) and Weil (1996) provide a more favorable assessment of the OSHA inspection process. However, even Dorman (1996), who supports an aggressive public policy to reduce workplace injuries, provided a qualified interpretation of such evidence: ‘ even the most optimistic reading indicates that … more vigorous enforcement alone cannot close the gap between U.S. safety conditions and those in other OECD countries. ’

In addition to the questionable effectiveness of OSHA inspections, some of the standards promulgated by OSHA have been criticized as excessively stringent. Viscusi (1996) examined OSHA standards using an implicit value of life of $5 million (derived from the compensating wage differential studies) as the standard for an efficient regulation. Four of the five OSHA safety regulations, but only one of the five OSHA health regulations adopted as final rules, had costs per life saved of less than $5 million. This evidence caused Burton and Chelius (1997) to provide a strong critique of the government mandate theory:

To be sure, cost-benefit analysis of health standards issued under the OSHAct is not legal, and so those standards that fail the cost-benefit test (considering both the lives saved plus injuries and illnesses avoided) do not violated the letter and presumably the purpose of the law. But to the extent that the rationale offered by the government mandate theorists for regulation of health is that workers lack enough information to make correct decisions and therefore the government is in a better position to make decisions about how to improve workplace health, the evidence on the variability of the cost/benefit ratios for OSHA health standards is disquieting. Rather than OSHA standards reflecting interventions in the marketplace that overcome deficiencies of the marketplace, the explanation of why the stringency of regulation varies so much among industries would appear at best to be a result of technology-based decisions that could well aggravate the alleged misallocation of resources resulting from operation of the market and at worst could reflect relative political power of the workers and employers in various industries.

6. Conclusions

This review suggests that understanding the economics of workplace safety involves a rather eclectic mix of theories. Burton and Chelius (1997) were least impressed with the arguments and evidence pertaining to the pure neoclassical economics and the government mandate theories. They concluded that among the other economic theories pertaining to safety, no single theory provides an adequate understanding of the causes and prevention of workplace accidents. Rather, a combination of the theories, though untidy, is needed.

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