The corporate average fuel efficiency (CAFE) standards are often denigrated as being less efficient than a gasoline tax at increasing the overall efficiency of fuel use (and reducing greenhouse gas emissions). Part of this inefficiency is that CAFE amounts to micromanagement of the economy, and produces all sorts of strange distortions in the economy. We all know about the "SUV loophole", which encouraged automakers to sell more of these gas guzzlers, but did you know that increasing CAFE standards benefits foreign car companies? I suspect that it also benefits large car companies.

 

Both of these effects are due to the fact that CAFE focuses on the corporate average fuel efficiency. This mean that there is no cost to selling a gas-guzzling vehicle as long as a fuel-efficient vehicle is also sold by the same company.  Some companies (Japanese, for example) already specialize in high-mileage cars, so increase CAFE standards would not affect them. Conversely, other companies (European, for example) completely ignore CAFE and just pay a fine. It's only the American car companies that optimize their production in response to CAFE, and it's only American car companies that would have to change their behavior in response to CAFE.

 

Considering these dynamics, think about someone who is trying to start a new car company, and only has one model of car. If it's mileage is above the CAFE standard, then he has to pay an extra fee. If it is below the CAFE standard, then he doesn't benefit from the intra-firm subsidy that small cars get in big companies that are trying to meet CAFE standards. In terms of our earlier discussion, CAFE imposes extreme transaction costs on car companies, thereby favoring consolidation.  Even if a small company has two models (one below CAFE and one above CAFE), they are still at greater risk of random fluctuations in the market pushing their average far above or below the CAFE standards. (If you don't understand why, read up on the Law of Large Numbers). This lead me to wonder if CAFE had anything to do with the consolidation of the American car industry. I couldn't find a detailed description of what happened, but it seems that most consolidation occurred in the 60's, while CAFE was enacted in 1975.

 

To his credit, Bush's proposal to increase CAFE standards includes a provision to allow companies to trade CAFE credits, which should decrease transaction costs and make the whole system more efficient.

 

Tip to How The World Works (Salon.com)