South-Western College Publishing - Economics  
Paying the Price of Pollution
Subject Externalities
Topic Government and the Economy
Key Words Standard, Fines, Cost, Lawsuits
News Story

CAFÉ rules regulate Corporate Average Fuel Economy. The idea is that auto makers each have to sell a mix of vehicles that on average have a certain average fuel economy level in a given model year. For cars, the standard is 27.5 miles per gallon (mpg) in combined city and highway driving. For light trucks the standard is 20.7 mpg. If the standard is breached, the federal government levies fines: $5.50 per 0.1 mpg under the standard per vehicle sold. The fines can be avoided by bettering the standard in the previous three years or forecasting offsetting future improvements. Auto makers also can define the model year to improve their performance: for example, GM did this when it shortened the 98 model year so that it ended in January 1998.

Some foreign auto makers, such as Mercedes-Benz and BMW, pay huge fines each year because they generally only sell larger vehicles. They see the fines as a cost of doing business. In contrast, US auto makers are reluctant to be prosecuted under the law under which the fines are imposed. They fear that shareholders might file lawsuits over company decisions to break the law and pay fines.

(Updated August 1, 1999)

Questions b) Show the effect of these externalities on your diagram. Mark the social equilibrium. c) Are too few or too many cars being produced from society's viewpoint?
1. Draw a diagram of the market for automobiles, showing the marginal private benefit and the marginal private cost curves. Mark the private equilibrium.
  a) What kinds of social costs result from the burning of gasoline by automobiles?
2. The federal government penalizes those with unduly low fuel efficiencies.
  a) Which curve is affected by the fines?
  a) On your diagram, draw the effect of the fines. How do they affect the private equilibrium price and output of cars?
3. In addition, US auto producers believe that they would face shareholder lawsuits if they ever broke the law.
  a) Which curve would be affected by the fines?
  b) On your diagram, show the effect of lawsuits. How would they affect the private equilibrium price and output of cars?
4. a) Why are Mercedes-Benz and BMW content to say that the fines are a cost of doing business and are less responsive in changing their mix of cars (compared to the average carmaker)?
  b) Explain how the diagram you have drawn for previous questions may be somewhat different for such producers.
Source James R. Healy, "Carmakers detour around CAFE rules," USA Today, July 2, 1999.

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