## Thursday, October 23, 2014

### Market Structure for Automobiles and Light Trucks -- the old Corporate Average Fuel Efficiency System

Market Structure for Automobiles and Light Trucks  -- the old Corporate Average Fuel Efficiency System

Often, even when regulation can be theoretically justified, it is difficult to create a rule, which creates the desired result.   Companies are clever.     This post shows that the original fuel efficiency regulation provided an incentive for companies to adjust their product mix sometime through merger rather than make cars with better gas mileage.

Question:    In my simple hypothetical market two types of automobiles are sold.  Fuel efficiency numbers for the two automobiles and the quantity purchased for each vehicle are presented below.

 Auto Sales and Fuel Efficiency for a Hypothetical Market # of Automobiles Sold mpg 1 1500 20 2 1000 38

A law requires that the fleet harmonic average for all vehicles sold in a model year meet at least 27.5 mpg?   Firms that fail to meet this average must pay a fine equal to \$5.50 for each 0.1mpg below 27.5 times the number of vehicles sold.

What is the fuel efficiency fine for a firm that sells 1500 cars that get 20 miles per gallon?

What is the fuel efficiency fine for a firm that sells 1000 cars that get 38 miles per gallon?

What is the fuel efficiency fine for a firm that sell 2500 cars – 1500 getting 20 mpg and 1000 getting 38 mpg?

Discuss the likely impact of the fuel efficiency regulation on market structure in the automobile industry?

Calculations:   The fuel efficiency average for the firm with only a 20 mpg vehicle is 20.    The firm is 7.5 percentage points below the legal limit.  Since 7.5/ 0.1 is 75 the fine per car is \$5.50 x 75 or \$ 412.50.    The total fine for this firm is 1500 x \$ 412.50 or \$618,750.

The fuel efficiency average for the car that only makes the 38 mpg car is 38 mpg.   This fleet average for this firm exceeds the limit that would trigger a fine.   This firm is not fined.

The fleet average for the firm that sells 1500 cars that get 20 mpg and 1000 cars that get 38 mpg is

AVG = (1500 + 1000) / ((1/20) + (1/38))

or 24.6753

 Harmonic Average Calculation # of Automobiles Sold mpg N/mpg Answer 1 1500 20 75.0000 2 1000 38 26.3158 2500 101.3158 24.6753

Note (27-24.6753)/0.1 is 28.2468.

The fine in this case is 28.2468 x \$5.50 x 2500 or  \$388,393.

Discussion:   The total fine calculations presented above understate the amount that might be saved by a small-firm automobile firm and a large-firm automobile firm combining.   The fine per vehicle is \$412 for the firm that sells no small cars compared to \$155 for the firm that produces both the small and large vehicles.

Under this scheme, it is possible for a firm planning to build large gas guzzlers to avoid the fuel efficiency fine by simply purchasing a company that also builds small cars.   (Extra credit: How many 38 mpg cars would a company that wants to sell 1500 20 mpg cars have to sell in order to avoid the fuel efficiency fine?)

The old fuel efficiency law gave a substantial advantage to multi-line firms – Toyota, Honda, GM and Ford – over smaller firms like Mercedes and BMW.   The only firms that have paid fuel efficiency fines in the United States are smaller European firms with narrower lines.

The merger between Mercedes and Chrysler temporarily allowed Mercedes to reduce its fines.

The fuel efficiency regulations in the United States have changed.   The required fuel efficiency now varies for cars of different size.   It is now possible to build a fuel-efficient large car and avoid fines.   This change in the fuel efficiency law is probably one of the factors that allowed Mercedes and Chrysler to break up.

Concluding thought:  The main point from this post is that is possible – perhaps even likely – that fuel efficiency regulations in the United States could have a larger impact on firm structure than on car or fleet fuel efficiency.   The rules have changed.  Fuel efficiency vehicles for each car now vary with the footprint or size measure.

The new system is really complex.   It is probably an improvement but the devil is always in the details.  I intend to learn more about the new system and its issues soon.

People interested in this post will also be interested in a previous post that explores how fuel efficiency regulations treat alternative fuel vehicles.