Can proactive fuel economy strategies help automakers mitigate fuel price risk?

Detroit automakers have opposed mandated improvements in fuel economy since legislation was first proposed in the 1970’s. Their opposition is based, among other considerations, on the assumption that their customers value fuel economy only when fuel prices are high. This paper presents the findings of our on-going research that strongly refutes this assumption. Using data on sales, prices, and attributes of vehicles in 2005, we find that consumers are willing to pay, on average, $578 per MPG for higher fuel economy. At the price of gasoline prevailing in 2005, $2.30 per gallon, the $578 per MPG that consumers are willing to pay for fuel economy implies that consumers put more weight in choosing vehicles on future fuel savings than most analysts (including ourselves) had thought. The paper incorporates these new data-driven estimates of the value of fuel economy into an automotive market simulation model that has three components: a consumer demand function that predicts consumers’ vehicle choices as functions of vehicle price, fuel price, and vehicle attributes (the new estimates of the value of fuel economy are used to set the parameters of the demand function); an engineering and economic evaluation of feasible fuel economy improvements by 2010; and a game theoretic analysis of manufacturers’ competitive interactions. Using our model, we estimated the market shares and profits of automakers in 128 separate scenarios defined by alternative plausible values for the price of fuel and consumers’ discount rates. Under the fuel price risks and the competitive risks that automakers face, our analysis concludes that a proactive strategy of pursuing fuel economy improvements— above and beyond what is required by law—would increase annual profits for Ford ($0.5 billion to $1.4 billion), GM ($0.2 billion to $0.5 billion, and DaimlerChrysler ($0.1 billion). Even if the uncertainty over fuel price were removed, all three automakers would increase profits by pursuing fuel economy improvements, though the gains are smaller with fuel at $2.00/gallon.