Rasha Ahmed Department of Economics University of Connecticut

1
Rasha AhmedDepartment of EconomicsUniversity
of Connecticut

• Emissions Control and Promoting Green Product
  Markets
• The Case of Automobiles

2
Introduction

• Pollution can result from
• Production processes.
• Environmental performance of a product, e.g.
  Fuel/energy consumption (e.g., cars, appliances,
  etc.).
• Firms can produce different models that differ in
  their energy/fuel use (e.g., large/luxury vs.
  small/economy cars).

3
Introduction

• Green products are those models of a product
  that cause less environmental damages than their
  counterparts.
• Substitution towards green products can reduce
  environmental damages.
• Several regulation to achieve this, e.g., the
  appliances minimum efficiency standards (MES) and
  the US CAFE standards which is an average
  efficiency standards (AES).

4
Example Automobiles market

• In 1975 Congress passed the Energy Policy and
  Conservation Act which established Corporate
  Average Fuel Economy (CAFE) standards.
• CAFE standards set miles per gallon (mpg) limit
  for new passenger cars sold in the US.
• The standards are to be met on a fleet-wide
  average.

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Example Automobiles market

• Flexibility Firms can meet CAFE by improving
  fuel economy or increasing sales of the models
  that exceed the standard.
• Since CAFE is an AES, it allows luxury models to
  exist, which is not possible under MES.
• The initial standard was 18 mpg for model year
  1978 and then was increased to 27.5 mpg in 1985.
• The new energy bill requires automakers to boost
  their fuel economy to a fleet average of 35 mpg
  by 2020.
• Despite concerns about the negative impact of
  CAFE on the automobiles market, policy makers
  continued to use CAFE as the main policy tool.

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Problems with CAFE

• A trade off between environmental friendliness or
  energy efficiency and other quality attributes.
• The National Academy of Science shows that the
  CAFE system has led to vehicle downsizing,
  potentially reducing safety.
• In addition, it is believed that CAFE will always
  have a negative impact on firm profits. Kleit
  (2002) estimates that raising CAFE by 3mpg will
  result in losses to automakers of 1.124 billion.

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Purpose

• This paper compares two alternative approaches to
  regulating markets of polluting products, using
  the automobile industry as an illustration
• CAFE-type regulation (as a form of an AES), and
• Quota-based regulation (as a general form of a
  MES).

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Key Questions

• Analyze and compare the impact of each policy on
  firms
• How does each policy affect firm profit?
• Is regulation always costly to firms?
• Does the increased flexibility of CAFE relative
  to the quota benefit firms?
• For a given level of environmental quality, which
  policy approach would firms prefer?

9
Key Questions

• Analyze and compare the welfare impacts of each
  policy
• Are consumers always worse off when polluting
  products are regulated?
• Does the level of emissions decline with
  tightening the regulation?
• Can the regulation improve social welfare?
• Which policy is more efficient?

10
Basic Modeling Approach

• Technology Two possible versions of a product
• Luxury (brown) model.
• Economy (green) model.
• Market structure Duopoly with Cournot
  competition.
• Product Line Model competition between models.
• Exogenous Quality Menu firms respond to the
  policy by altering product mix.
• No Green Preferences consumers are
  differentiated based on the extent of use.

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Basic Modelling Approach

• Tradeoff between fuel economy and other quality
  attributes Higher mpg generally achieved through
  using lighter material and sacrificing other
  dimensions, e.g. acceleration, power, roominess
  and cargo capacity. (Crandall, 1989 Crandall,
  1992 Plourde and Bardis, 1999 Chen, 2001
  Kleit, 2002)
• While this tradeoff exists for automobiles, it
  also applies to other products as well, e.g.,
  recycled paper.

12
Tradeoff MPG and performance
Source Shanjun Li (2007)
13
How different from Green Product Models?

• No green Preferences differentiation based on
  private characteristics
• Assumes a product line where each firm produces
  both the green and the brown product rather than
  specialize in a single product quality.

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Summary of Results

• Not all regulation of polluting product markets
  is costly to firms, i.e. regulation can increase
  industry profit.
• The increased flexibility that a policy provides
  may not be beneficial to firms
• CAFE-regulation gives firms more flexibility in
  output choice than the quota. However, this
  flexibility is actually detrimental to firms
  since it intensifies competition between firms
  relative to the quota.
• In contrast, a quota can increase industry profit
  over a certain range (creates an implicit form of
  collusion enforced by the quota).

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Summary of Results

• Consumers are always worse off under a quota,
  while consumers surplus under CAFE increases over
  a certain range.
• Total emissions declines under a quota, which is
  not necessarily true under CAFE.
• Whether social welfare improves under the
  regulation (CAFE or Quota) will depend on the
  magnitude of damages.
• When damages are high enough a quota policy is
  more efficient than CAFE.

16
Related Literature

• Minimum quality standards e.g., Ronnen (1991),
  Crampes and Hollander (1995), Ecchia and
  Lambertini (1997), Maxwell (1998), Scarpa (1998),
  Lutz, et al. (2000), Valletti (2000).
• Firms produce a single quality. No competition
  between products for a given firm

17
Related Literature

• CAFE standard e.g. Crandall (1992), Kleit (2002)
  and Goldberg (1998) describe the effect of CAFE
  regulation on market sales and profit. Greene
  (1991), Thorpe (1997), Plourde (1999) and
  Harrington (2006).
• Describe the firms reaction to the standard in
  terms of quality choice. No consideration of
  alternative policy tools, other than a gasoline
  tax

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The Model

• The economy (luxury) model uses
  units of energy per use (e.g., gasoline per
  mile), where .
• Consumers vary with respect to a single
  parameter, ?, which represents extent of use and
  is uniformly distributed on 0,1.
• No green preferences, i.e., product is
  vertically differentiated ? for same price, all
  consumers prefer luxury model.
• Consumers either buy one unit of the product, the
  economy model or the luxury model, or do not buy.
  The number of consumers is normalized to 1.

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The Model

• Consumers get utility from buying model i
  denoted by
• Where
• the performance of model i and .
• is the energy price.
• is the energy consumption per use of model i
  and
• is the price of model i.
• and i E, L.

20
The Model

• The utility can be simplified to
• where is a parameter
  representing the overall quality of model i, and
  is independent of the consumers type.
• Assume that , i.e., for a given
  price all consumers perceive the luxury model to
  be superior to the economy model.

21
The Model

• Given the values of the parameters and the
  equilibrium prices, we define the cut off values
  for ?.

1
22
The Model

• Consumers buy the luxury model if they are of
  type where,
• Consumers buy the economy model if they are of
  type
• where,
• Consumers whose do not buy since buying
  yields a negative utility.

23
The Demand

• The inverse demand functions can be obtained by
  substituting the values of and ,
  setting N1 and inverting to get

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Firms choice

• Firm j maximizes profit given by
• subject to the regulation.
• Two types of regulation
• CAFE type standard (Average efficiency standard)
• Quota on the output of the brown (low efficiency)
  model.

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CAFE

• An upper limit on the weighted average energy use
  across models produced by each firm
• This simplifies to , where
  .

26
Quota

• An upper limit on each firms output of the low
  efficiency model.
• Varying K or Z allows a comparison of profits
  under differing stringency of regulation.

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Pre-regulation

• The pre-regulation equilibrium can be described
  by the following proposition
• Result
• Note In equilibrium, there is no product
  differentiation, i.e. both firms produce both
  models.

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Impact of Regulation

• Result Under both types of regulation, relative
  to the pre-regulation equilibrium
• Production of the economy model expands, while
• Production of the luxury model shrinks,
• However,
• While, the prices of both models rise under a
  quota, under CAFE the price of the economy model
  initially declines, price of the luxury model
  rises and total output increases.
• The impact on firm profit is different under the
  two approaches.

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Impact on sales
Pre-regulation
0
1
Quota
1
0
CAFE (Less stringent)
0
1
CAFE (more stringent)
0
1
Buy the luxury model Buy the economy model Dont
buy
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Equilibrium Locus and Profit
Tightening CAFE, i.e., reducing Z, gives new
equilibrium points
Tightening quota, i.e., reducing K, gives new
equilibrium points
CAFE
.
.
Quota
.
O
Iso-profit line
Collusion point
31
Effects of the Policy

• While the quota restricts each firms choice of
  output, it gives each firm a strategic advantage
  by restricting each competitors output choice.

32
Quota and Profit

• Result Tightening the quota increases firm
  profit over a certain range.
• The quota effectively provides a means for
  collusion between firms.

33
CAFE and Profit
Result Tightening the CAFE standard always
reduces profit. Competition to supply the luxury
cars under CAFE results in an expansion in the
economy car market and a lowering of its price.

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Competition CAFE vs Quota
There is more competition under CAFE that leads
to more production and a lower profit equilibrium
than under a quota
CAFE
.
.
.
Z
Quota
B
A
O
Iso-profit line
K
35
Emissions CAFE vs Quota
For a give level of total emissions firms prefer
quota over CAFE since .
.
Iso-emissions line
CAFE
.
C
.
.
Quota
B
A
O
Iso-profit line
36
Distributional effects

• We can implement the quota with a system of
  permits.
• Each permit gives the firm the right to produce
  one unit of the luxury model.
• Reducing the number of permits is equivalent to
  tightening the quota.
• The impact on firm profit will depend on the
  means of allocating the permits among the
  identical firms
• If equally distributed at a zero price ? same
  effect as quota.
• If sold at a market clearing price ? profit gain
  acrues to the government as permit revenue.

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Impact on Consumers

• Consumers are worse off under a quota since
  prices of both models increase.
• However, overall consumers surplus can increase
  over a certain range under CAFE since the price
  of the economy model declines and total sales
  increase.

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Impact on Emissions

• Total emissions decline under a quota.
• While CAFE achieves a reduction in average energy
  consumption, it does not guarantee a reduction in
  total emissions.
• For certain values of the parameters, it is
  possible that total emissions increase with
  tightening CAFE.

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Emissions CAFE vs Quota
If is small enough, then initially
tightening CAFE results in higher emissions than
the pre-regulation level.
Emissions
Iso-emissions lines
CAFE
.
Quota
O
40
Impact on Social Welfare

• A market with two imperfections
• Externality (overproduction)
• Imperfect competition (underproduction)
• The impact of each policy on welfare will depend
  on which imperfection dominates, i.e. the impact
  on welfare will depend on
• Magnitude of d, unit damages from emissions
• Magnitude of the parameters

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When d0

• Imperfect competition is the only market failure.
  CAFE can raise social welfare, while quota always
  reduces welfare.

.
CAFE
Iso-welfare line
.
Quota
O
42
When d is high enough

• The quota can raise social welfare. CAFE may or
  may not raise welfare.

If CAFE always reduces emissions
CAFE
If CAFE can raise emissions
.
Quota
.
O
Iso-welfare line
43
Policy Choice

• Case 1 CAFE always reduces emissions, and
  therefore always raises social welfare.

For low values of d, the optimal quota is non
binding
44
Policy Choice

• Case 2 If CAFE may raise emissions, then it is
  not always welfare enhancing.

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Conclusion

• Not all regulation of polluting product markets
  is costly to firms, i.e. regulation can increase
  industry profit.
• CAFE-regulation gives firms more flexibility in
  output choice than the quota. However, this
  flexibility is actually detrimental to firms
  since it intensifies competition between firms
  relative to the quota.
• In contrast, a quota can increase industry profit
  over a certain range (creates an implicit form of
  collusion enforced by the quota).
• If regulators are primarily concerned about the
  impact of regulation on firms, it may be
  politically more feasible to use a quota rather
  than CAFE.

46
Conclusion

• Consumers are always worse off under a quota,
  while consumers surplus under CAFE increases over
  a certain range.
• Total emissions declines under a quota, while it
  is possible that total emissions increase under
  CAFE.
• When damages are high enough a quota policy is
  more efficient than CAFE.