Using Loopholes to Reveal the Marginal Cost of
Regulation: The Case of Fuel-Economy Standards
By Soren T. Anderson and James M. Sallee*
Estimating the cost of regulation is difficult. Firms sometimes reveal costs indirectly, however, when they exploit loopholes to avoid regulation.
We apply this insight to fuel economy standards for automobiles. These standards feature a loophole that gives automakers a bonus when they equip a vehicle with flexible-fuel capacity. Profitmaximizing
automakers will equate the marginal cost of compliance using the loophole, which is observable, with the unobservable costs of strategies that genuinely improve fuel economy. Based on this
insight, we estimate that tightening standards by one mile per gallon would have cost automakers just $9–$27 per vehicle in recent years. (JEL L51, L62, Q48)
We analyze the market for flexible-fuel vehicles that burn ethanol. While interesting in its own right, this market is especially important because it indirectly provides information about the cost of tightening the fuel-economy standards that apply to all automobiles. Efforts to reduce gasoline consumption in the United States have historically focused on mandating vehicle efficiency through CAFE standards. The merits of these standards are not always clear, in part because it is difficult to measure the cost of regulation in the absence of market prices and because automakers have an incentive to overstate the costs of compliance. Domestic automakers claim that aggressive increases in CAFE standards would cost them tens of billions of dollars in profit, force them to close plants and cut tens of thousands of jobs, increase car prices by thousands of dollars, and “cripple” the domestic auto industry.
We estimate that the marginal compliance cost of the CAFE standard, as revealed by profit-maximizing behavior in the auto industry, was relatively low during much of the last decade. To do so, we demonstrate that automakers exploit an incentive or “loophole” in CAFE regulation that allows them to relax CAFE standards up to a point by producing flexible-fuel vehicles. We show theoretically that constrained automakers will equate the marginal cost of improving fuel economy using flexible-fuel vehicles with the marginal cost of improving fuel economy through other means. Thus, because we can observe the cost of producing a flexible-fuel vehicle, automakers that produce flexible-fuel vehicles without exhausting the loophole indirectly reveal their marginal compliance costs. Based on this approach, we estimate that tightening CAFE standards by one mile per gallon would have cost domestic automakers only $9–$27 in profit per vehicle in many recent years. Our estimates are substantially lower than estimates in other recent studies, which use different methodologies and require a broader set of assumptions. Our estimates are also well below the $55 statutory fine, a plausible upper bound, which has been used as a cost estimate in previous research.