Don’t Drink the CAFE Kool-Aid

Hal J. Singer and Robert W. Crandall
Robert W. Crandall Adjunct Senior Fellow - Technology Policy Institute

September 6, 2007

Several bills are working their way through Congress that would increase the corporate average fuel economy standard (CAFE) for cars and light trucks by 4% per year, reaching a target of 35 miles per gallon by 2018. Aside from economists, whose voices often carry little weight in Washington, there is virtually no opposition to this form of regulation. Not even from a Republican president.

To bolster support for these new rules, CAFE proponents have issued two studies that purport to show that increasing the CAFE standard to 35 miles per gallon would generate fuel savings for car owners in excess of the admittedly higher costs of automobiles; increase carmakers’ profits; and generate nearly a quarter of a million U.S. jobs.

A study by the University of Michigan’s Transportation Research Institute supports the first two alleged benefits of increasing CAFE, and the third alleged benefit is touted by the Union of Concerned Scientists. Unfortunately, elementary economic principles require one to conclude that the directional change of more stringent CAFE standards on consumer welfare, carmakers’ profits, and jobs is exactly the opposite of what these studies suggest.

No one disputes that more stringent CAFE standards would increase the cost of making a car, which would be passed on to buyers. Technologies that improve fuel economy are costly (“there is no free lunch”). Forced to climb to a higher standard, carmakers would embrace the most cost-effective technologies first. But to reach the final rungs on the fuel-economy ladder, carmakers would have to employ very expensive technologies and reduce various aspects of vehicle performance, such as acceleration and vehicle size.

The bone of contention between the carmakers and the regulators (principally the National Highway Traffic Safety Admission) concerns exactly how much those technological improvements would cost in relation to the present discounted value of fuel savings for car owners over the life of the car.

Ask any economist and he’ll tell you that estimating the private costs and private benefits of increasing fuel economy is a fool’s errand. This is precisely the job of a well-functioning market. For example, if there was fuel-saving technology out there that cost $1,000 but generated $2,500 in the discounted present value of fuel savings over the life of the vehicle, carmakers would surely voluntarily embrace that technology. The carmaker could split the net benefits (equal to the difference between the discounted fuel savings and the cost of the technology) with the car buyer such that both parties to the transaction would be better off.

No need for regulation there. With large numbers of vehicle producers and well-informed consumers, the market is so efficient, in fact, that it ensures that all such transactions will occur, generating the socially optimal level of fuel economy. Markets may generate too little fuel economy if there are social benefits not captured fully by private parties, but CAFE proponents have failed to demonstrate such external benefits. Indeed, external benefits are not even part of their argument.

According to our preliminary estimates, every new GM customer would incur a net loss of several hundred dollars under the newly proposed standard, as the higher cost of the car would exceed the discounted fuel savings. Multiply this loss per vehicle by the number of new vehicles sold and you arrive at annual welfare losses in the billions of dollars.

Regarding the second purported benefit of increasing CAFE, it is naïve to think that carmakers need regulations to increase their profits. As explained above, if a carmaker sees an opportunity to add value for their customers in excess of costs, it will do so. The purpose of regulation is to curb behavior that is profit-maximizing but generates some external cost to society. Thus, regulation typically reduces profits. CAFE proponents seem to have forgotten this basic point.

Finally, the claim that increasing CAFE standards would generate nearly a quarter million U.S. jobs cannot withstand economic scrutiny. First, requiring carmakers to spend more money on cars only diverts resources away from more productive endeavors. No country can expand its wealth by employing people in activities that entail more costs than benefits. Second, the costs of excessive fuel-economy standards are added to the price of the vehicles, inducing consumers to buy fewer new cars, thereby reducing overall vehicle sales. Thus, while carmakers would be spending more to come into compliance with the higher standards, car buyers would be spending less on cars in the aggregate because the newer cars would be more expensive. Demand curves slope down, which means an increase in the price of cars would generate fewer car sales.

Any call for regulation must be based on a market “failure” — that is, failure of private markets to provide the proper incentives for contributing to social value. In the case of the current call for increases in CAFE, the market failure is generally identified as global warming or national security. But CAFE is a horribly inefficient mechanism for reducing carbon emissions because it does nothing to reduce emissions from power plants, older vehicles, home furnaces or industrial facilities. Nor would it apply to any emissions outside the U.S. Even if one accepts the debatable proposition that less reliance on oil would improve our national security, we should focus our attention on all oil consumption, not just that used in new vehicles. The cost of trying to reduce the harmful external effects of any form of consumption by arbitrarily taxing just 5% of it is extremely costly. A smaller tax on a much wider tax base always reduces the distortions caused by the tax.

When exposed to the piercing light of economic analysis, the alleged benefits of more stringent CAFE standards burn away. Too bad these proposals will not be subjected to economic scrutiny before they become law.

Mr. Crandall is senior fellow in economic studies at the Brookings Institution. Mr. Singer is the president of Criterion Economics. They have advised General Motors on CAFE issues.