Cover-Up of Vehicle Defects: The Role of Regulator Investigation Announcements

Abstract

Automakers such as Toyota and GM were recently caught by the U.S. regulator for deliberately hiding product defects in an attempt to avoid massive recalls. Interestingly, regulators in the U.S. and U.K. employ different policies in informing consumers about potential defects: The U.S. regulator publicly announces all on-going investigations of potential defects to provide consumers with early information, whereas the U.K. regulator does not. To understand how these different announcement policies may affect cover-up decisions of automakers, we model the strategic interaction between a manufacturer and a regulator. We find that, under both countries’ policies, the manufacturer has an incentive to cover up a potential defect when there is a high chance that the defect indeed exists and it may inflict only moderate harm. However, if there is only a moderate chance that the defect exists, only under the U.S. policy does the manufacturer have an incentive to cover up a potential defect with significant harm. We show that the U.S policy generates higher social welfare only for very serious issues for which both the expected harm and recall cost are very high and the defect is likely to exist. We make four policy recommendations that could help mitigate manufacturers’ cover-ups, including a hybrid policy in which the regulator conducts a confidential investigation of a potential defect only when it may inflict significant harm.

Keywords: product recalls, automotive industry, socially responsible operations, public policy