The cost of CAFE standards: Not as high as we thought?

Yesterday's TREE Seminar featured Jim Sallee of the University of Chicago. Sallee presented an interesting paper that uses a clever yet simple method to estimate the cost to car companies of meeting CAFE standards.

Here's the abstract:

Automakers can comply with fuel economy regulations by exploiting a loophole that gives a bonus to flexible-fuel vehicles. Under certain conditions, firms will equate the marginal cost of using the loophole, which is observable, with the unobservable costs of other compliance strategies, such as selling smaller cars or upgrading technology. After verifying that these conditions hold empirically, we estimate that tightening standards by one mile per gallon would cost automakers $8–$18 in lost profit per vehicle. Our estimates are considerably lower than other recent estimates based on structural identification. Our approach may help reveal compliance costs for other regulations.

So car companies can achieve CAFE standards by either making their cars more fuel efficient or, alternatively, exploiting a loophole that allows them to instead make more "flex fuel vehicles" that can run on both ethanol (E85) or regular gasoline. The CAFE credit they get for these conversions combined with the cost of converting a regular gasoline car to a flex-fuel car turns out to be between $8 and $18 per car per MPG.

Okay, first off, this has NOTHING to do with whether the loophole is a good idea--whether we should be encouraging car companies to make flex-fuel vehicles or whether ethanol policy generally makes any sense. Save those thoughts for another day.

The point is that car companies will choose the lowest-cost method of meeting the CAFE standard. And since achieving that standard using flex-fuel loophole is probably less than $18 per car, the cost of changing the overall standard can't cost more than this amount, at least for small changes.

Cool idea. And that 's a very small cost per car--much less than estimated in earlier studies.

Most of the paper is a careful dotting of all eyes and tees to verify the assumptions one needs to draw this inference. I'm trying very hard to find a flaw and cannot.

Okay, so if this number is right we should all be very sick to our stomachs because it implies the costs of reducing carbon emissions, at least on the margin, is very, very low. So why aren't we doing this already? (No, I'm not advocating stricter CAFE; gas taxes or a cap-and-trade system would be the better policy route.)

Update: To put this number in perspective: Rather than an upper bound of $18 per MPG per car, let's bump it up to $20 to be conservative. Then consider that a typical driver drives about 14,000 miles/year, or to be conservative let's say it's 10,000 miles, suppose a car's useful life is 10 years (again conservative), and that a typical new car currently gets about 25 MPG (also conservative). Then then it costs $20 in car company profits save about 154 gallons of gas, or about 13 cents per gallon. If I wasn't so conservative (especially with regard to current MPG), the cost could easily be half this amount.

Since this is more than order of magnitude less than the price of gas, even at today's cheap prices, one may wonder why consumers' aren't happy to pay this cost. Note, however, that this is a measure of impact on automobile company profits, not the price of the car, so that would be reading the analysis wrong.

Still, it's an incredibly low number.