The Price of Gas and the Demand for Fuel Economy: Are There Any Links?

Many economists advocate higher fuel taxes as a means to reduce oil consumption and carbon emissions from the transportation sector. But just how effective are taxes at reducing fuel demand? Not very effective, apparently, based on the limited responses to the recent run up in fuel prices.

In the ongoing public debate over reducing U.S. gasoline consumption for national security and environmental reasons, many economists support an increase in the federal gasoline tax as the most efficient policy. In principle, such an increase should curb gasoline consumption by reducing average miles traveled per household and by increasing the average fuel economy of vehicles on the road. But the empirical evidence shows that the elasticity of miles traveled to the price of gasoline is small (roughly -0.1), having almost no effect in the short run.

Consequently, a large increase in the gasoline tax would be needed to substantially reduce consumption—that is, unless average fuel economy of the vehicle fleet responds to the price of gasoline. That response includes many factors such as at what age vehicles are retired, but an important component is the effect of the price of gasoline on the average fuel economy of new vehicles. Although the roughly three-fold increase in the price of gasoline from 2002 to 2007 significantly affected sales of individual vehicle models, the effect on average fuel economy was quite small.

Price vs. Demand

Between the beginning of 2002 and the end of 2007, as the real price of gasoline doubled, the market share of SUVs, with a mean fuel economy of about 16.7 miles per gallon (MPG), decreased from 17 to 12 percent. The market share of the three U.S. manufacturers (Chrysler, Ford, and GM), which relied heavily on SUV sales during this time period, decreased from 63 to 52 percent.

After controlling for variables that affect market shares, such as consumer preferences for vehicle characteristics, about half of the decline in market shares of SUVs and U.S. manufacturers from 2002 to 2007 was due to the coinciding increase in the price of gasoline. Despite the strong relationship between gasoline prices and market shares in this one vehicle category, gasoline prices have had only a small effect on the average fuel economy of all new vehicles sold. A $1 per gallon increase in the price of gasoline is associated with an increase of only about 0.5 to 1 MPG after controlling for other factors.

In the short run, of course, vehicle characteristics are fixed. The simultaneous large effect on model market shares and small effect on fleet average fuel economy can be explained by the fairly narrow distribution of fuel economy of vehicles in the market at a particular time. For example, a sudden increase in the gasoline price could cause a dramatic shift from medium size to small cars, but the change in overall fuel economy would be small because the average fuel economy of these two market segments is similar, at 26.6 and 30.3 MPG.

How Manufacturers Respond

In principle, the long-run effect of gasoline prices on average fuel economy could be greater if producers responded by offering vehicles with higher fuel economy. Some of these adjustments can be rather quick, such as changing the mix of vehicles offered, but others take some time. When the corporate average fuel economy (CAFE) standards were implemented in the mid-1970s, manufacturers raised fuel economy by making vehicles shorter and lighter and by reducing engine sizes. Consequently, vehicle weight and power (as measured by horsepower) decreased by about 30 percent. Yet the reduction in engine power was quickly reversed as the price of gasoline declined and technology improved. By 1990, average vehicle power had returned to its pre-CAFE level.

It is technologically feasible for producers to significantly increase fuel economy through either an increase in production costs (by substituting lightweight alloys or adding a turbocharger and downsizing the engine) or a reduction in engine power. Given consumers’ strong preferences for vehicle performance, firms are hesitant to compromise engine power in order to increase fuel economy.

So where does this leave us? The price of gasoline has a very small effect on the fuel economy of the stock of vehicles on the road. A very large increase in the gasoline tax would be needed to reduce consumption because the price per gallon has so little effect on miles traveled and the fuel economy of the overall vehicle fleet. The political feasibility of such an increase is doubtful at best and substantially reducing gasoline consumption solely by increasing the gas tax would not seem to be a viable policy option.
Other options do exist, including improving public transportation, increasing the CAFE standard or offering cash or tax incentives to consumers. Examples of the latter include federal and state tax incentives for purchasing hybrids and the recent “cash-for-clunkers” program.

Ultimately, the full costs and benefits of each policy need to be compared, although such a comparison is far from straightforward. In the case of CAFE, its costs are largely hidden from the consumer’s view; it is not obvious to consumers the extent to which fuel economy standards affect new and used vehicle prices and cause an increase in driving (that is, the “rebound” effect). But perhaps more importantly, it is necessary to consider how policies and economic forces might interact with one another when comparing costs and benefits and addressing political obstacles. For example, high gas prices can increase public support for raising fuel economy standards, as in the 1970s and perhaps in the past few years, although the reverse would be true in periods of low gas prices. Multiple policies might also interact positively with one another; for example, improving public transportation could increase the sensitivity of miles traveled to the price of gasoline. In such cases, a combination of policies might prove politically and economically expedient. 
  

Thomas H. Klier is a senior economist in the economic research department at the Federal Reserve Bank of Chicago. His work focuses on the effects of changes in manufacturing technology, the spatial distribution of economic activity and regional economic development.

Joshua Linn is an assistant professor in the department of economics at the University of Illinois at Chicago. His primary areas of research and teaching interest are energy economics, environmental economics, and industrial organization. 

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