Consumer Heterogeneity and Gasoline Price Response: Implications for Optimal Tax policy

Measuring consumer response to gasoline price changes is a fundamental issue in the design and regulation of environmental externalities. In this paper, we document the importance of accounting for heterogeneity in consumer utilization of durable goods in explaining the apparent undervaluation of future fuel costs. We develop a Bayesian method within the context of heterogeneous discrete choice model paired with pricing equations derived from Bertrand competition to estimate heterogeneous demand elasticity for gasoline price changes, and use our results to conduct counterfactual analyses of alternative tax policies. We find that accounting for heterogeneity in utilization and other dimensions all but eliminates undervaluation of future operating costs. Results from our counterfactual analyses imply that gasoline taxes lead to welfare increases that are 20% higher than those obtained under a fuel economy regime.