Product design response to policy: Evaluating fuel economy standards using an engineering model of endogenous product design

Policies designed to improve industrial environmental performance are increasing in scope and stringency. These policies can significantly influence engineering design decisions as firms reoptimize their products and processes to meet compliance requirements at minimum cost. This paper demonstrates the importance of accounting for these design responses in the analysis of policy impacts. As a case in point, we model automotive firms’ medium-run compliance choices under the reformed Corporate Average Fuel Economy (CAFE). Physics-based simulations are used to characterize the potential for improving fuel efficiency through design changes. These engineering simulation results are coupled with a partial-equilibrium, static oligopoly model in which firms choose prices and key vehicle design attributes. We simulate firms’ pricing and medium-run design response to this regulation. Results indicate that firms rely primarily on changes to vehicle designs to meet the reformed CAFE standards, with a smaller contribution coming from pricing strategies designed to shift demand towards more fuel-efficient vehicles. The analysis also draws attention to two factors that could offset potential fuel efficiency improvements achieved under the reformed CAFE standards: an increase in the market share of light trucks and an increase in the market share of firms that choose to violate the standard. * The authors would like to thank Severin Borenstein, Lawrence Goulder, Mark Jacobsen, Ryan Kellogg, Chris Knittel, James Sallee and seminar participants at the University of Michigan and the University of California, Berkeley for their helpful suggestions. We also thank Ashley Langer for valuable help with the demand estimation, Bart Frischknecht and Deokkyun Yoon for assistance with vehicle simulations, and Kevin Bolon for help managing the data sets. Financial support for this work is provided by the National Science Foundation and the University of Michigan Rackham Graduate School and is gratefully acknowledged. † K. Whitefoot is now a Senior Program Officer at the National Academy of Engineering. Address:500 5 St, Washington, DC 20009. Email: [email protected]. Website: www.designscience.umich.edu/kwhitefoot.html. ‡ Address: 301 Giannini Hall, UC Berkeley, Berkeley CA 994720. Email: [email protected].