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The Costs Of Fuel Economy Economics Essay

A change in climate is frequently referred to as a global warming problem, whereby individuals are unlikely to take responsibility for their actions and for the global increase of atmospheric greenhouse gases (NRC 2002, p.9). Human actions all over the world are causing increasingly large quantities of greenhouse gases which result from the consumption of fossil fuels. Most experts believe that accumulation of gases such as CO2 in the atmosphere will have an outcome in variety of environmental changes, particularly a gradual warming of the global climate (Shackleton 2009, p.1).

Concerns about climate change are not normally reflected in the market for buying and selling of cars. In this market the costs that consumers to incur are the direct costs that they will bear, including the purchase price of the car, its operational fuel costs, maintenance costs, registration, insurance, taxes, the resale value over time and other costs (NRC 2002, p.9). Hardly any consumers take into account the environmental costs that the use of their cars may occasion.

When speaking in terms of economics, this is seen as a classic negative externality, and it is to be expected that very little fuel economy would be purchased in this case (NRC 2002, p.9). For this reason it is appropriate for the government to take measures that would better align the true costs to society with use of vehicles to the signals that consumers face with. These measures could take any form, from simple taxes on petrol to internalize the externality to regulatory requirements designed to improve the fuel economy of the cars people buy (NRC 2002, p.9).

Fuel economy has been attracting public and official attention in the way not seen for almost two decades. Oil prices have risen dramatically over the past few years and fluctuated unpredictably ever since. Also, concerns have developed over the availability of the supply of oil in the future. A lot of evidence also suggests that global climate change should be taken seriously, European cars, and other forms of transport are responsible for a large fraction of the world’s annual emissions of carbon dioxide, the most headlined greenhouse gas (NRC 2002, p.7). Is it time to achieve the higher levels of fuel economy? Or do such regulations do more harm than good? And what are the intangible costs of introducing the fuel economy? All these questions are answered in this essay.


Throughout the history, the transportation sector has always been overflowing with continuous innovations, most of which were small and incremental but some were cumulative and has led to reorganization and restructuring.

At this point in time, according to well known study of Sperling and Lutsey (2009) the best reductions in green house gas emissions and oil use in the transport sector are most likely to emerge from low-carbon fuels and improved motor vehicle efficiency. But in due course the entire system transformations will be central to the introduction of the fuel economy.

Although vehicles have become more comfortable as well as much safer, the efficiency, structure, and performance of the surface passenger transport system have not changed much structurally for almost 80 years. In essence, cars, rail transits and buses all have the same functional performance, and are still the most dominant modes of transportation for people. Even though over the years there has been a lot of interest in the advanced control technologies and sensors to introduce automated highway lanes for cars and trucks, most of these efforts have failed because of many legal proceedings and even more safety concerns (Sperling & Lutsey 2009).

In the automotive industry, information and communication technologies are referred to as ITS or intelligent transportation systems (Sperling & Lutsey 2009). Local governments have embraced these latest technologies but have limited its implementation only to improve the road use management and to provide travelers with access to navigational devices and services that provide information to ease driving anxiety, destination search times, and provision of the emergency services (Sperling & Lutsey 2009).

Because the present pattern of single occupant vehicle use is so inept, opportunities would seem to be there for improving fuel efficiency through major system-level changes. However expansion of conventional transportation such as full-size buses and rail transport would not be the answer. At present, transport buses in Europe consume about the same quantity of fuel per passenger kilometer as light vehicles, mainly because of low average usage (Sperling & Lutsey 2009). Rail transport is to some extent better in terms of use of fuel per passenger kilometer, with exception for some eastern countries and a number of other heavily populated cities that have heavy railway usage during peak as well as non-peak hours. Overall, for much of the day, rail transportation is set apart by light use, which equals to large average fuel use per rider.

Undoubtedly, increased usage of conventional transport would result in less fuel-intensive travel. However this is unlikely unless there is a dramatic increase in the cost of operating or owning a car. Nonetheless there was an increase of annual public transportation usage by 4 percent, placing public transit usage in 2007-2008 period at a 50-year high, this increase has erupted as a result of soaring oil prices, followed by an economic recession which started in 2007-2008 (Sperling & Lutsey 2009). Even with these changes the combined effect of transport is still minor in terms of reducing overall fuel use (Sperling & Lutsey 2009).

If, however, new mobility services combined with changes in land use were created using intelligent transportation systems and other highly advanced technologies, changes with much larger fuel and green house gas benefits might be achieved. Another factor that can encourage this change is a shift in individual preferences, such as interest in urban amenities, also a shift in people’s values with regard to environmental concerns, and the cost of car ownership and operation. For this type of diversified system to develop, there have to be adjustments not only in the preferences that people have, but also in policies and organizations that preside over land-use running and the provision of transportation services (Sperling & Lutsey 2009).

Fuel-Efficient Vehicles and Challenges Facing the Substitute Fuels

In 2010 there were over 522 million vehicles in the whole of Europe. The average life of a vehicle is estimated at thirteen years, meaning that it will take at least this long for a newer more efficient cars or models of cars to replace the existing less efficient models (Gallagher 2009, p.75). If the more efficient cars have lower performance or are seen as less appealing, than the rate of dissemination will be even slower.

In 2007 governments passed energy regulations, which increased the corporate average fuel economy standard not only in Europe but in many other parts of the world as well. The expectation is that the new law would significantly reduce oil consumption. Yet subsequent analysis shows that the income effect, as millions of Europeans become wealthier and per capita GDP increases, will swamp the impact of having more efficient cars on the road, and that almost no reduction in oil imports or carbon emissions in 2030 relative to 2010 base emissions will occur (Gallagher 2009, p.75). This is the same phenomenon that happened with the original corporate average fuel economy standards when they were implement two decades ago. Since these standards were enacted, vehicle fuel consumption in Europe has increased by over 40%, primarily because as people became wealthier they bought many larger, more luxurious, more powerful cars and drove more (Gallagher 2009, p.75).

The new legislation requires that over 30 billion of gallons of renewable fuel be blended into petrol by 2022 (Gallagher 2009, p.75). Some of this fuel is projected to come from corn-based ethanol, with the remainder to come from second generation biofuels, which are projected to rely on cellulosic material. There is a rising concern that carbon emissions over the lifecycle of the production chain of for some biofuels may not be significantly less than the carbon emissions from normal unleaded petrol production (Gallagher 2009, p.75). In addition, to grow the biomass for the biofuel will require a large amount of land, during a period when the world’s population is continuing to grow. Using the land previously used for food will increase the food prices, put added pressure of forests, threaten biodiversity, and put pressure on water supplies. Furthermore, if Europe wants to pursue biofuels as an energy option, as opposed to stimulus for European farmers, it should lower its import tariffs and encourage the use of cheaper biofuels produced from sugarcane (Gallagher 2009, p.76). These problems are solvable but not without a significant government intervention.

According to Gallagher (2009) other potential substitutes face equally hard challenges. Many people argue that there is a potential in the extraction of liquids from coal. That may be true; however, the production of this process releases too much carbon to be environmentally friendly and will require extensive investments in technologies to capture and store the released carbon. The production of gas supplies requires significant amounts of water and faces steep regulatory challenges. Hydrogen has an enormous potential, but it is a secondary energy source, meaning it needs large amounts of electricity in its production (Gallagher 2009, p.76). Finally electric vehicles will need to increase their range if they are to attract buyers. This can be achieved through breakthroughs in battery technologies.

Gallagher (2009) was right on point when she concluded what was said above all in one sentence: “all of these sources of fuel economy have potential, but all face major challenges and will not make significant contributions without major efforts by both government and the private sector.”

Fuel Price and Income Effects

Transport is the one sector of economy where substitution with other fuels has been negligible. Consumer responses to changes in fuel prices are often measured through elasticities (JTRS 2008, p.18). Even though the price elasticity of fuel is fairly low, meaning it has a low impact on demand, this however does have a big impact on the demand in the long run (JTRS 2008, p.18). Although fuel consumption declines when petrol prices increase, expenditures do increase. The outcome is that there is a shift in allocation of expenditure where goods and services lower consumption in other parts of the economy, and result in a shift of wealth to domestic as well as foreign oil producers.

Higher fuel prices have an effect on demand in two ways. First, consumers respond by driving less. And second, they devote more into fuel economy by desiring more fuel efficient vehicles. Latest evidence suggests (JTRS 2008, p.18) that these two effects have changed in its importance, meaning that the responsiveness of consumers to driving less has reduced and that the bigger share of response is now dominated by consumers investing into improved fuel economy. Smaller responses in terms of less driving mean that the overall fuel price elasticity of demand is more limited. Price effects are offset by the income effect, which means that as the income rises the fuel consumption rises as well (JTRS 2008, p.18).

An analysis was conducted by Phil Goodwin, Mark Hanly and Joyce Dargay under the title ‘Review of Income and Price Elasticities in the Demand for Road Traffic’. They summed up their findings on the price elasticity of demand of petrol along these lines:

‘If the real price of fuel goes, and stays at that level, up by 10%, then the result is a dynamic process of alteration such that:

The volume of traffic will go down by roundly 1% within about a year, building up to a reduction of about 3% in the longer run (about five years or so).

Efficiency of use of fuel goes up by about 1.5% within a year, and around 4% in the longer run.

The reason why fuel consumed goes down by more than the volume of traffic, is because price increases trigger more efficient use of fuel (by a combination of technical improvements to vehicles, more fuel conserving driving styles, and driving in easier traffic conditions). So further consequences of the same price increase are:

The total number of vehicles owned goes down by less than 1% in the short run and 2.5% in the longer run.

The volume of fuel consumed will go down by about 2.5% within a year, building up to a reduction of over 6% in the longer run. (2007)’

It's important to note that the realized elasticities depend on factors such as the timeframe and locations that the study covers - the realized drop in quantity demanded in the short run from a 10% rise in fuel costs may be greater or lower than 2.5%. Goodwin et al (2007) find that the price elasticity of demand is -0.25 in the short run, with a standard deviation of 0.15, while in the long run the price elasticity of -0.64 has a standard deviation of -0.44.

While it cannot be said with absolute certainty as to what extent a rise in gas taxes will impact on quantity demanded, it can be reasonably guaranteed that a rise in gas taxes, all else being equal, will cause fuel consumption to decrease (Goodwin et al 2007, p.4).

Understanding the Fuel Economy Program

Because of the complexity of new car markets, which are best characterized as oligopolies, predicting the effects of fuel economy programs is inherently difficult (Anderson et al. 2010, p.9). Usually, car makers offer a selection of models to the same customer base. Therefore, a car manufacturer that decreases the price on one of its vehicle models will decrease demand for its other models, while draw off customers away from other firms. According to Anderson et al. ‘automakers choose many physical attributes besides price to package into a particular model. Market equilibrium is usually modeled as a Nash outcome, in which firms cannot profitably deviate by changing prices or vehicle attributes given the choices of other firms’ (2010).

If fuel economy programs are compulsory and obligatory, they limit a firm’s profit maximizing choices. Compliance strategies include changing vehicle’s characteristics either by incorporating expensive fuel saving technologies or compromising other car attributes, such as size and horsepower or changing relative prices to increase the sales shares of more efficient models (Anderson et al. 2010, p.9).

Vehicle redesign is likely responsible for most improvements in fuel economy to date because studies find that compliance costs are substantially lower in the long run when automakers can redesign vehicles to be more efficient. Fuel economy regulations place an implicit tax on inefficient vehicles and changes in vehicle attributes that reduce fuel economy, while subsidizing efficient vehicles and changes that improve fuel economy. With separate standards for cars and light trucks, these taxes and subsidies operate separately within these two fleets, meaning that large cars are taxed while potentially less efficient small trucks are subsidized, creating a perverse incentive to redesign large cars as trucks (e.g., the Chevrolet HHR and Chrysler PT Cruiser).4 Moreover, in the absence of provisions that allow credit trading between firms, foreign firms like Honda and

Toyota that perennially exceed U.S. standards face no implicit taxes or subsidies. This means that tighter standards may harm the competitive position of domestic U.S. automakers while perversely allowing unconstrained foreign automakers to produce the large vehicles that domestic firms would have produced otherwise.

Tighter fuel economy standards only affect new vehicles. Thus, when the standard increases, overall fuel economy improves gradually for about 15 years as new vehicles replace the old. By lowering fuel costs per mile, fuel economy standards also encourage more driving.

Recent evidence for the United States suggests this “rebound effect” is fairly modest, however, offsetting just 10 percent of the fuel savings resulting from higher fuel economy (e.g., Small and Van Dender 2007). Both the rebound effect and gradual turnover cause fuel taxation to be more efficient than fuel economy standards in conventional economic models (e.g., Austin and Dinan

The Types of Policies Adopted

The introduction of fuel economy and cost of reducing emissions would depend vitally on the approach that governments and policymakers adopted to achieve that goal. In particular, costs would depend on whether the policy worked primarily through conventional regulation or market based approaches, on the strictness of emission reductions, and on other policy choices (Shackleton 2009, p.3).

Conventional Regulation vs. Market Based Approaches

A basic choice that policymakers face with is whether to adopt conventional regulatory approaches, regulations such as setting emission standards for cars and other forms of transport modes, or to make use of market based approaches, such as setting up taxes on emissions or launching cap & trade programs. Robert Shackelton (2009) generally concluded that market based approaches would cut down emissions to a certain level at a much lower cost than conventional regulations. While conventional regulatory approaches inflict precise requirements that may undeniably not be the least costly means of reducing emissions, Shackelton (2009) says that market based approaches would offer much more latitude for manufacturers to settle on the most cost effective means of achieving that goal.

Alternative Market Based Approaches

If there was a tax imposed on emissions, consumers would make cutbacks that are less costly than the tax, and the incremental cost would be equal to the tax rate (Shackleton 2009, p.4). Proposals for such tax initiatives generally have rates that rise annually, with aim of making activities that produce a lot of emissions very expensive. Cap & trade proposals openly restrict the amount of emissions that can be produced over a specific time period. The allowances for how much greenhouse gases can be released are allocated to different manufacturers, who than can trade it with the other firms. Cap & trade proposals usually allocate caps that gradually decrease with time in absolute terms, so firms would gradually incur rising incremental costs to reduce emissions (Shackleton 2009, p.4).

If policymakers had complete or accurate information about the costs of reducing emissions, either taxes or caps could be used to achieve a given goal for emissions. Policy makers could use a cap and know what allowance price it would yield, or they could use tax at that same allowance price and achieve the same reduction in emissions (Shackleton 2009, p.5). Therefore either approach could be used to balance the incremental costs of reducing emissions aligned with the incremental benefits of doing so, thus achieving the maximum achievable net benefit. Still, policymakers are faced with great uncertainty about cost of reducing emission. It is likely that the two approaches will yield two different results: a tax on emissions would leave the amount of emissions uncertain, whereas a cap would leave the resulting allowance price uncertain (Shackleton 2009, p.5).

Anderson et al. posit that ‘studies based on historical data may not provide reliable estimates of the future costs of fuel economy regulations and policies. Cost estimates are sensitive to assumptions about baseline fuel economy (without policy) which can change substantially over time’ (2010). For example, rising oil prices in the future, or progress on fuel saving technologies, could shift baseline demand toward more efficient vehicles, thereby reducing the effectiveness and costs of a given fuel economy standard.

Policymakers (FIA 2009, p.19) have recommended to many countries to display the outcome of fuel economy testing with standard windscreen labels, as many countries and car showrooms are already obligated to follow this practice. In recent times, many countries altered their labelling systems to provide more realistic levels of CO2 emissions and their information on vehicle fuel consumption. All these labels are connected to a uniform testing procedure. However, even between neighboring countries labeling schemes of today notably differ. Especially in Europe there is a wide range of labeling systems that are different from each other. To provide reliable signals to consumers and manufacturers across international car markets, synchronization of labeling system is necessary, as this would improve effectiveness and maximize their overall efficiency (FIA 2009, p.19).

There are likely to be a lot of benefits from the international alignment of fuel economy testing, tax rate and labeling systems to create an increasingly global car markets with reliable indicators for marketing and product development (FIA 2009, p.19). Countries that already have fuel economy policies in place, increasing alignment with other countries will only occur with time, as these policies are renewed and adjusted. For countries and regions where policy-making is just beginning, alignment may be possible more quickly by way of jointly developing similar policy systems across clusters of nearby countries (FIA 2009, p.19).

The Use of Alternative Powertrains and Its Market Penetration

At present, less than 13% of the new vehicles in the European market are turbocharged petrol, diesels, or hybrids, but their market shares are expected to grow. When the first Honda Insight hybrid was introduced, the sales of hybrid vehicles have grown from 6,000 units in year 2000, to 213,000 units in 2006 (Heavenrich 2006). It is also expected that more diesel passenger vehicles are to be made available in the next few years. Increasing the market penetration of these currently available alternative powertrains, in particular the more efficient hybrids can bring us closer to the desired fuel economy and cleaner environment. The overall benefit attained from alternative powertrains depends on how quickly these new advanced technologies can penetrate the existing range of vehicles in the car market.

Advanced technology vehicles will face many difficulties and barriers to gaining the market share. The challenges would be to overcome high initial costs, reliability, safety tests, and many durability concerns, fuel availability, and perhaps one of the biggest barriers to overcome, would be a lack of awareness (Sperling & Lutsey 2009). Market penetration rates and a market share are likely to rise at a snail's pace unless fiscal and regulatory policies are altered dramatically, because all advanced technology vehicles will be competing against steadily improving low petrol consumption vehicles.

The wait between the introduction of advanced vehicle technologies and their effects on the total use of fuel is an essential phase on the way to realize long term reductions.

The impact of advanced technology vehicles will certainly be far larger in the longer term of about 50 years, than in the near 25 years, short term (Sperling & Lutsey 2009). Advanced vehicle technology introduction needs to start as early as possible to realize those great reductions.

Motivated by lower taxation of diesel fuel over petrol and innovations in common rail injection, in Europe, the share of diesel cars grew at an average rate of 9% per year to capture about half of the market today (Cheah et al 2007, p.14). Other previous automotive technologies such as 2 or 4 wheel drive vehicles and automatic transmission have all over periods of 15 to 20 years infiltrated into the other markets at a rate of 7 to 11% per year in the past (Cheah et al 2007, p.14). Based on these rates, it can be assumed that the maximum combined annual growth rate of alternative powertrains in the European market is 10% per year. This correlates to a maximum 85% share of alternative powertrains in new vehicle sales in 2035 (Cheah et al 2007, p.14). In other words, if turbocharged petrol engines, diesels and hybrids are aggressively promoted, only 15% of new vehicles brought onto the roads in 2035 will remain powered by conventional, naturally-aspirated petrol internal combustion engines.

For simplification, the relative proportion of turbocharged petrol to diesel vehicles that penetrate the market is initially fixed. Assuming that the more efficient hybrids remain more popular than other powertrains in the European market, the share of turbocharged petrol and diesel vehicles are each fixed at five-sevenths of the hybrid market share. (Cheah et al 2007, p.14) Thus, in the extreme scenario of 85% alternative powertrains in 2035, hybrids account for 35% of the new vehicle market, while turbocharged petrol and diesel vehicles each account for 25% of the market (Cheah et al 2007, p.15). This constraint will be relaxed later in order to gauge the sensitivity of allowing a different market mix of alternative powertrains (Cheah et al 2007, p.14).


Oil use and greenhouse gas emissions are steadily on the rise throughout the world because of seemingly unavoidable growth in demand for passenger and goods transportation by all transport modes. The challenge is to first balance this growth, and then to reduce fuel consumption and green house gas emissions.

Over the next 20 to 30 years a reduction of 30% to 50% in the fuel consumption of new light duty vehicles is possible. To achieve these changes the uncertainty lies with the time, rather than with the technological options on hand to realize them. Policymakers and governments would need to give the public time to buy smaller more efficient vehicles. They also would need to provide the car factories with time to retool. Many transportation strategies are highly cost effective for reducing fuel use and green house gas emissions. When calculating future fuel savings using normal discount factors, improved petrol and diesel cars have the potential to create large cost savings over the lifetime of the fuel saving technology or product. What could lead to even far greater efficiency gains is the use of alternative-fuel technologies while also moving away passenger transportation from the use of petrol. When the full range of benefits such as improved fuel security, reduced urban traffic congestion, and positive climate change are taken into account, several vehicle efficiency and green house gas mitigation options seem even more attractive.

Even so, there are substantial barriers to extensive implementation of efficient, low carbon technologies and practices. In the absence of vehicle fuel and climate policies, car consumers have traditionally gone for larger vehicles, with more sophisticated accessories, and more speedy acceleration. High prices of oil have led to increased sales of less thirsty, smaller and more efficient vehicles, but only for the short term. Unless policies, actions, and market circumstances change, fuel efficiency improvements will be implemented at a slow pace.

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