Using Loopholes to Reveal the Marginal Cost of Regulation: The Case of Fuel-Economy Standards

Corporate Average Fuel Economy (CAFE) regulations constrain automakers to produce vehicles whose average efficiency exceeds a minimum standard. A “loophole" in the program allows firms to relax this constraint by producing gasoline-ethanol flexible-fuel vehicles, which are credited with far better mileage than they actually achieve. In this paper, we demonstrate that when firms use this loophole, they reveal the marginal cost of complying with the standard. This is because firms equate the marginal cost of relaxing the constraint via the loophole with the marginal cost of complying through other means, such as selling smaller vehicles or installing fuel-saving technologies. We show that under certain conditions the marginal cost of relaxing the constraint via the loophole is a simple function of readily available parameters. We demonstrate empirically that these sufficient conditions hold in recent years for major U.S. automakers. We calculate that the cost of increasing CAFE standards by one mile per gallon is between $8 and $28 in lost profit per vehicle for domestic automakers. These costs are far lower than other recent estimates based on more complicated methodologies. Unlike these other estimates, our costs are well below the noncompliance penalty of $55, which should serve as a plausible upper bound, and which has been used as a cost parameter in previous research. More generally, the loophole methodology we develop here may help reveal marginal compliance costs for other regulations whose costs are otherwise difficult to gauge.