Structural Analysis of Vehicle Design Responses to Corporate Average Fuel Economy Policy

The U.S. Corporate Average Fuel Economy (CAFE) regulations, which aim to influence automaker vehicle design and pricing responses, have been imposed for thirty years, with new target regulations enacted in 2007. This paper will present a structural analysis of automaker responses to generic CAFE policies. The paper will depart from prior CAFE analyses by focusing on vehicle design responses in long-run oligopolistic equilibrium, and will view vehicles as differentiated products, taking demand as a general function of price and product attributes. The paper will find that firm responses to CAFE standards follow a distinct pattern: Firms ignore CAFE when the standard is low, treat CAFE as a vehicle design constraint for moderate standards, and violate CAFE when the standard is high. The violation point depends on the penalty and the vehicle design is independent of the standard. Thus, increasing CAFE standards will eventually have no impact on vehicle design if the penalty for violation is not also increased. The paper will implement a case study using vehicle simulation, cost models, and mixed logit demand model to examine equilibrium price and engine size decisions with a fixed vehicle body. The paper finds that current standards are near the violation point, although numerical predictions are sensitive to vehicle assumptions. Firm responses are more sensitive to fuel prices than to CAFE standards, with the 2007 average fuel price implying that current CAFE standards are too low to affect vehicle design. A CAFE violation penalty keeping pace with inflation would create a wider CAFE effectiveness band than the current stagnant penalty.