Kate Whitefoot, Meredith Fowlie, and Steven Skerlos “Product Design Responses to Industrial Policy: Evaluating Fuel Economy Standards Using an Engineering Model of Endogenous Product Design”  (February 2011) (Revised 2017) (Revised version published in Environmental Science & Technology, 51(18): 10307-10315, August 2017) | WP-214R

Policies designed to improve industrial environmental performance are increasing in scope and stringency. These policies can significantly influence engineering design decisions as firms re-optimize 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 industrial policy impacts. As a case in point, we model automotive firms’ medium-run compliance choices under the reformed Corporate Average Fuel Economy (CAFE) regulation. Physics-based simulations are used to characterize the potential for improving fuel efficiency through medium-run 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 perform counterfactual simulations of firms’ pricing and medium-run design responses to the reformed CAFE regulation. Results indicate that compliant firms rely primarily on changes to vehicle design to meet the CAFE standards, with a smaller contribution coming from pricing strategies designed to shift demand towards more fuel-efficient vehicles. Simulations that account for medium-run design responses yield estimates for compliance costs that are nine times lower than simulations that only account for price changes. Moreover, our simulations suggest that as compliant firms increase fuel efficiency, it becomes more profitable for non-compliant firms to adjust product designs to improve other performance attributes at the expense of fuel efficiency. This effect has the potential to significantly offset the fuel efficiency improvements achieved by compliant firms.