Gas prices wouldn't hurt so much with stricter fuel efficiency laws

Gas prices would be less painful if the US government raised fuel economy standards for new vehicles. Do perks, like being more immune to high gas prices, count as a 'free lunch' from the government?

Damian Dovarganes / AP
A motor home leaves a gas station after filling up for the long Memorial Day weekend in Valencia, Calif., Friday, May 27, 2011. Gas prices are still topping $4-a-gallon in much of the country, but drivers with fuel-efficient cars aren't hit quite as hard.

By raising new vehicle fuel economy standards by 3 to 6% per year, the U.S government is offering us lower annual gasoline bills, less greenhouse gas emissions, and safer roads (if we all drive around in smaller cars we end the "arms race" on our roads as the laws of physics F=M*A holds). In this editorial , the NY Times implicitly says that this is a "free lunch".

Do economists agree? Are we so nasty that we do not support higher disposable income, less climate change, and increased safety? Perhaps, but there is another issue lurking.

Chris Knittel, a MIT economist, has a paper that will published soon in the American Economic Review. Here is an old version. Here is a quote from my friend Chris' paper;

"New car fleet fuel economy, weight and engine power have changed drastically since 1980. These changes represent both movements along and shifts in the “fuel economy/weight/engine power production possibilities frontier”. This paper estimates the technological progress that has occurred since 1980 and
the trade-offs that manufacturers and consumers face when choosing between fuel economy, weight and engine power characteristics. The results suggest that if weight, horsepower and torque were held at their 1980 levels, fuel economy for both passenger cars and light trucks could have increased by nearly
50 percent from 1980 to 2006; this is in stark contrast to the 15 percent by which fuel economy actually increased."

So, what does this mean? For profit firms build cars that people want to buy. While car makers have had the capacity to build highly fuel efficient vehicles (the 50% increase), they have chosen not to do so. If car buyers solely cared about fuel bills and climate change, then the car makers would have already achieved the 50% increase in fuel economy and new vehicles would already be achieving 40 MPG.

So, this is a long winded lead-in to the point that as regulation required MPG increases --- many car purchasers will be less happy with the new vehicles they are buying. This loss in "consumer surplus" is ignored by many in the regulatory community when considering the true cost of this regulation. Intuitively, there are people who want to buy Hummers and don't want to trade them for a Prius.

Optimistic regulators are implicitly assuming that carmakers will figure out how to have "the best of both worlds" (i.e a vehicle that looks like a Hummer that achieves 40 MPG). If this is impossible and whole types of large vehicles can no longer be sold on the new car market, certain consumer segments will disproportionately suffer a loss in consumer well being. For the economists, the field of structural IO has been thinking about this for a long time (see Berry, Levinson, Pakes, Petrin, Knittel and others).

The regulators are assuming that the MPG of a vehicle can be increased without affecting any of its other attributes. Knittel's work shows that this can't be right.
Suppose that General Motors and Exxon were a merged monopoly profit maximizing company. In this case, the conspiracy theorists would be right that GM would have an incentive to sell fuel guzzling vehicles because this raises Exxon's profits. In this case, government regulation could nudge us to a better MPG equilibrium.

In reality, GM and Exxon are separate companies and GM only considers its profits from selling cars. If consumers want smaller vehicles (perhaps because world gas prices are rising), then GM has an incentive to sell them. Knittel's work shows that GM has an increased ability to make such vehicles (due to technological advance) but it has chosen not to (which reveals that people don't want them). Now, the government will force the ramp up in MPG and the key issue here is what vehicle attributes that people value will be removed from the next generation of vehicles to allow the companies to meet the mandate?

I support the rising MPG for the fleet (due to the GHG externality and the road safety externality) but I want there to be an honest discussion of the cost of new vehicle regulation. To actually have this discussion, the government must welcome in the structural IO economists.

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