On the Determinants, Financial and Operating Consequences, and the Product Market Effects of Product Recalls

Abstract

We study a large sample of product recalls that include a wide variety of products such as consumer products, food, drug, medical devices, and automobiles and show that such product quality failures have significant adverse value consequences for the recalling firms. Our analysis sheds light on factors that affect the incidence of product recalls, the financial and operating consequences for the recalling firms, and the actions taken by them in response to the recall. We also study the value implications for the rivals and suppliers – which enable us to draw important inferences about product market linkages. We find that the financial condition, competitive position, coordination costs, incentives of workers and management, and monitoring environment impact recall likelihood. Recall events result in significant costs for key suppliers which are further exacerbated if they have made larger relationship-specific investments. Further, instead of benefiting from the recalling firms’ problems, industry rivals suffer adverse contagion effects, perhaps due to anticipated regulation and diminished perceptions about the product category. We find that a larger investment in brand capital alleviates the negative wealth effects for the recalling firms. Finally, using a difference-in-differences approach, we find that recalling firms suffer sales declines and increase advertising expenditures – consequences and policy changes that we further show are not just due to a continuation of a differential trend from before the recall event and, therefore, directly attributable to the recall.

Keywords: product market interactions, leverage, financial distress, incentive compensation, contagion, product recalls

JEL Classification: G32, G33, K13, L15