Is a 56.2 MPG Fuel Economy Standard Really a Good Idea?

 According to news reports, the Obama administration is talking to automakers about raising the Corporate Average Fuel Economy standard for passenger cars to 56.2 miles per gallon by 2025, more than double the  27.5 MPG in force for the 20 years up to 2010. Economists, even those like myself who favor policies to reduce fuel use, have argued that CAFE standards are a bad idea. Has anything changed to make stricter fuel economy standards look better now than in the past?

The fundamental problem with CAFE standards is that they attack the negative externalities of motor fuel use (pollution, national security concerns, highway congestion, accidents) only partially and indirectly. As a result, the cost of achieving a given reduction in fuel use via CAFE standards is higher than it would be if the same result were achieved more directly through an increase in the federal gasoline tax.

To understand why, we need to consider the various ways consumers can cut back on fuel use. In the short run, they they can buy an efficient hybrid instead of a gas-guzzling SUV, they can reduce discretionary driving, or they can shift some trips from their Ford F-250 to their Honda, if they happen to have one of each in the driveway. Given more time to adjust, they can make work and lifestyle changes like moving closer to public transportation, work and shopping, changing jobs, or working at home.

Higher fuel prices directly affect all of these choices. They encourage people to make whatever marginal adjustments best suit their circumstances. A recent New York Times article gave these examples of how people were reacting as gasoline approached $4 per gallon in May, 2011:

• An upstate New York customer relations manager moved to a new apartment that cut her daily commute from 50 miles to 8 miles. She preferred that to trading her beloved truck for a low-mileage vehicle.
• Traffic on San Francisco's bridges fell while ridership on buses and ferries rose.
• New York-based Topical BioMedics switched to cloud computing to make it more convenient for employees to work from home.
• A Los Angeles hair products business found more workers taking advantage of a long-standing offer of a 20-cent per mile bonus for car pooling.

The problem with higher CAFE standards is that they encourage fuel saving only with regard to the choice of what car to buy. Once a consumer buys a low-mileage vehicle, the cost of driving and extra mile goes down, thereby reducing the incentive for fuel-saving measures like moving closer to work, working at home, riding the bus to work, or consolidating errands.

The tendency of more fuel-efficient vehicles to induce additional driving is known as the "rebound effect." For example, suppose that the elasticity of demand for driving with respect to fuel-cost per mile is -0.3. That means a 10% increase in fuel efficiency would cause a 3 percent increase in driving. The increased miles driven would partly offset the increase in miles per gallon, so that total fuel consumption would decrease by only about 7%.

Even taking the rebound effect into account, higher CAFE standards are still somewhat helpful in reducing those externalities that are proportional to the quantities of fuel consumed, including externalities of pollution and national security. However, the rebound effect causes an absolute increase in those externalities that are proportional to miles driven, including road congestion and traffic accidents. It also increases the cost of road maintenance, because the wear and tear from more miles driven is only partly offset by the lower average weight of high-mileage vehicles.

The very fuel-saving strategies that CAFE standards discourage, like moving closer to work or consolidating errands, are often the ones that have the lowest costs. That is why the total cost of reaching a given national fuel-saving target will be greater when achieved through CAFE standards than when induced by an increase in fuel taxes. A 2004 study from the Congressional Budget Office concluded that an increase in the federal gasoline tax would achieve a given reduction in fuel economy at a cost 27 percent less than that of an equivalent tightening of CAFE standards. Furthermore, its effects would be felt more quickly, because they would not have to wait for the gradual turnover of the national motor vehicle fleet. Over the 14-year time horizon of the CBO study, the gas tax increase would save 42 percent more total fuel.

The variable most critical to the size of the rebound effect, and therefore to the relative merits of CAFE standards vs. fuel taxes, is the price-elasticity of demand for fuel. The less elastic is demand, the stronger is the case for CAFE standards; the more elastic, the larger the rebound effect and the stronger the case for raising fuel taxes. So what do we know about price elasticity?

Of all the many elasticity studies, the most widely cited is a 1996 meta-analysis by Molly Espey. She concluded that the best estimate for the price elasticity of gasoline demand was -0.26 in the short run and -0.58 in the long run. Those estimates strongly undermine the case for CAFE standards. However, Espey's results, which are based on data from 1936 through 1986, have been challenged by more recent estimates that show a decrease in elasticity in the early years of the 21st century.

In particular, a 2006 NBER working paper by Jonathan E. Hughes, Christopher R. Knittel, and Daniel Sperling found evidence that the short-run price elasticity of gasoline for the period 2001-2006 had fallen to a range of -0.034 to -0.077. That finding would seem to strengthen the case for higher CAFE standards.
The authors of the NBER study suggest several reasons that the elasticity of demand for fuel may have fallen during the period studied. One is that the real price of gasoline and its share in household budgets was below its historical average in those years. A second possible reason is that suburban sprawl and longer commuting distances meant that a lower proportion of all driving was discretionary. A third explanation was that after more than a decade in which CAFE standards had remained unchanged at 27.5 MPG, there were fewer opportunities for saving fuel by trading in an older car for a new one or shifting driving from one car to another within the family fleet.

But not so fast. Still more recent studies seem to show that the factors at work in 2001-2006 were temporary, and that after hitting a low, elasticity is on the rise again. A study by Todd Litman of the Victoria Transport Policy Institute, released just last month, provides a comprehensive review of the literature. His conclusion is that long-run fuel price elasticities have returned to a range of -0.4 to -0.8. In Litman's view, the rebound of the rebound effect (as he puts it) has occurred in part because rising fuel prices and stagnating incomes have once more increased the share of fuel costs in consumer budgets. Also, as a larger share of the population reaches retirement, a higher percentage of driving becomes discretionary, and therefore more sensitive to fuel prices.

It is worth noting that much of the observed variation in fuel prices on which the elasticity studies draw are market-driven, and therefore expected by consumers to be transitory. Elasticity is not only likely to be higher in the long run than in the short run, but also higher in response to changes in fuel prices that are expected to be permanent, such as those that would result from tax increases. The expectation effect would be even greater under a variable, price-smoothing oil tax of the type discussed in this earlier post. Such a tax would put a permanent floor under retail gasoline prices, providing maximum incentive to make the behavioral changes needed for long-run fuel economy. The effectiveness of higher fuel prices in mitigating externalities of automobile use would greater still if they were backed up by modern, time-of-day pricing policies for road use and parking, as well.

To be sure, not everyone will be convinced by elasticity studies. They are just numbers. Some people will continue to believe that prices have no effect on driving behavior, that people will just drive whatever and wherever they want regardless. Here is a picture, then, that is worth a thousand meta-analyses. Taken from the Litman study cited above, it shows a convincingly tight relationship between fuel prices and fuel use across OECD countries. Can it really be just coincidence that the United States, with the lowest fuel prices, also has the highest fuel consumption?

All this leaves one last question. If CAFE standards are such a bad idea, why do they remain so popular? If you are an economist, choosing higher fuel taxes over CAFE standards looks like a no-brainer, but if you are a politician, fuel taxes have an obvious drawback. Fuel taxes make the cost of reducing consumption highly visible. You see the big dollars-per-gallon number right there in front of you every time you drive up to the pump. CAFE standards, in contrast, hide the cost. You pay the price of a higher-mileage car only when you buy a new one, and even then, the part of the price attributable to the mileage-enhancing features is not broken out as a separate item on the sticker. You may notice that your new car costs more than your old one did, but there are lots of other reasons for that besides fuel economy.

It is a classic case of the TANSTAAFL principle—There Ain't No Such Thing As A Free Lunch. If you try to make something look like it’s free, it only ends up costing more in the long run. If you are a politician, you may well prefer a big hidden cost to a small visible cost. If you're a friend of the environment, you should know better.

Originally posted at Economonitor.com