Is there a point of diminishing return on improving fuel economy?

Ok, I know this is mostly an information technology blog (although when I started it my intent was to cover technology in general) but I want to talk about automotive technology right now.  As I do with IT topics I like to look at things with a bit of an economic slant.  Not a deep detailed analysis, but the kind of back-of-the-envelope analysis that can be used as a gut check on products, markets, etc.  And it turns out that the current relentless push for better fuel economy is a perfect place to do this.

To begin with I’m not going to address any environmental issues here for a very practical reason.  The overwhelming majority of car buyers do not actually buy based on the environmental impact of the vehicle they choose.  It is a secondary driver of their behavior, not a primary driver.

I have friends, family and acquaintances who are incredibly vocal about the problem of Global Warming/Climate Change, but if you look at what they drive they are not attempting to dramatically minimize their own contribution to this equation.  People’s real buying behavior is to first decide on a class of vehicle that meets their needs, then they narrow the choices down to those they can afford, then decide what subset of those they like, and only as part of that process do they really start to consider things like environmental impact.  And they mostly do that (in the U.S.) through the economics of Environmental Protection Agency’s (EPA) Miles-Per-Gallon (MPG) ratings.  So the better the EPA rating the less fuel consumed (and paid for) and the less carbon emitted.   No matter your position on Global Warming/Climate Change you win if you use less energy.  Everyone wins actually, even the energy companies.  Although an argument for that position is not in the scope of this blog.

A discussion of the EPA’s benchmark methodology, and EPA MPG ratings are indeed a metric derived from a benchmark, is in scope for this blog and at some point I’ll write about it in the context of benchmarking in general.  But not today.  Today we focus on MPG economics.

By 2025 the U.S. is supposed to have a Corporate Average Fuel Economy (CAFE) of 54.5 MPG.  That is a rather artificial metric used by the National Highway Traffic Safety Administration (NHTSA).  I’ve seen articles claiming this will equate to an average EPA sticker of 36 MPG and others claiming low 40s.  Different benchmarks.  Moreover, these are averages based on assumed mix of vehicles sold in 2025.  If buyers go for more midsize and smaller cars than planned then the U.S. fleet will beat these averages.  If they go for more large trucks, vehicle makers will have trouble meeting the CAFE goal.  Well maybe not.  The 2015 Ford F-150 looks like it will be close to meeting the 2025 30 MPG goal  for Large Trucks, making one wonder where they can get to in 10 years.

If we take government mandates out of this equation we see a trend emerging out in the real world.  The very popular midsize segment (e.g., Toyota Camry, Ford Fusion, Honda Accord, etc.) is already bumping up against the 50 EPA MPG rating in their Hybrid guises.  And hitting over 100 MPGe (a benchmark variant to take into account energy from the power grid) in their plug-in Hybrid variants.  And that is with 11 years, or basically two new vehicle generations, yet to come before midsize cars are estimated to average 53.8 EPA MPG.  You can have a 50 MPG class car today, and every year they become more common.

A few recent events in my life had me start wondering if there is a diminishing return on continuing to push improvements to fuel economy.  One of those events is that I’ve been driving one of the near 50 EPA MPG cars for the last six months.  Another is that we’ve been helping a friend look for a new house.  A third is I’ve had some family members make moves recently.  The first made me realize I hardly think about buying gasoline, or the expense of gasoline, any more.  The latter two made me think of scenarios.  The result was a thought experiment on if most car buyers will care about going beyond the 50 EPA MPG mark.

Let’s take two scenarios.  The first is someone living in an urban residential neighborhood.  They have a one-way commute of 5 miles or less.  The second is someone living in the suburbs.  They have a one-way commute of 25 miles or less.  Now obviously there are numerous other scenarios, but if we take the oft-repeated claim that the vast majority of drivers average less than 40 miles per day than our round-trip numbers of 10 (urban) or 50 (suburban) take in nearly the entire non-rural population of the U.S.  So these two scenarios seem worthy of analysis.

Let’s start with our Urban Dweller (UD).  UD has a commute of 50 miles per week, and with our 50 MPG car thus uses one gallon of gas.  Here in Colorado you can currently find regular gasoline for under $3.50 per gallon, but in some other areas of the country it is approaching $4.00.  For our analysis we’ll assume the price of a gallon of regular gasoline is $4.  So how much does UD spend on gasoline to get to and from work?  $4 per week.  That doesn’t sound like much.

For a gut-check do a comparison to mass transit.  A ride on the NYC subway is $2.50, which means a week of round-trip commuting travel is $25.  A 10 trip 2-zone bus/light rail ticket here in Denver is $20.  Now I know that comparing gas costs alone to a mass transit ticket is going to set off an apples to oranges alert in your head.  But I think it’s a valid gut check on variable costs.  If you own a car than most of the costs associated with it are incurred whether you drive it or let it sit in the garage.  The variable costs are mostly those associated with the fuel you use.  For mass transit more of their fixed costs are represented in the ticket price (although a lot of them are captured in taxes paid whether you use mass transit or not).  But for you as a commuter, the ticket price is purely variable costs.  You only pay them when you use the service.  And yes there are other variable costs, like parking, for using your car.  But since those occur regardless of MPG, and vary dramatically by where you work (free at office park vs. $ at downtown office building), I’m going to ignore them.

Let’s do another gut-check.  Colorado minimum wage is $7.78 per hour, so fuel for commuting takes less a little over a half-hour of work per week at the bottom end of income scales.  Colorado median personal income is $868 per week, so for most of us that gallon of gas is a truly irrelevant cost.

What happens if gas hits $5 per gallon?  At 50 MPG it is almost unnoticeable.  What if it hits $8 per gallon?  Obviously for a minimum wage worker every penny is noticeable.  But for a median income worker it’s one less cup of coffee per week in theory, and probably unnoticeable in practice.  And your variable transportation cost is still lower than it is with mass transit.

So let’s switch to our suburbanite (S).  S uses one gallon of gasoline per day, for a weekly fuel cost of $20.  A $1 rise in fuel price takes them to $25, or one less coffee per week.  A doubling of gasoline prices takes them to $40 per week.  While this extra $20 has clear impact on a minimum wage worker, it is also unlikely that you’d commute 50 miles round trip for such a job.  But for a median income worker we are talking about fuel taking another 2% of their income, not insignificant but not devastating either.

What about a mass transit comparison for S?  A LIRR monthly ticket for an approximately 25 mile distance from Penn Station comes to $65 per week.  Denver doesn’t have a commuter rail system, but an RTD Light Rail 4-zone (which does cover many suburbs) monthly ticket works out to $42 per week.  So for S even a doubling of gasoline prices means their variable transportation costs would remain under the cost of using mass transit.

Now let’s try to understand the value of increasing fuel economy.  At 75 MPG UD would save $1.36 per week.  Not enough for even a tall drip coffee at Starbucks.  At 100 MPG UD would save $2.00 per week.  Barely enough for that tall drip coffee.  At 75 MPG S saves $6.80 and at 100 MPG $10.  So a little more noticeable, but still not a significant benefit to their economic wellbeing.  We’re talking in the range of  switching from Tall Lattes to Venti Vanilla Lattes here.  And the problem in all of this is, we’re only looking at variable costs.

Our push to increase fuel mileage is increasing the fixed costs side of the equation.  A 50 City/45 Highway MPG City Honda Accord Hybrid starts at $29,155 while the 124/105 MPGe Honda Accord Plug-In Hybrid starts at $39,780.  There is no conceivable change in variable energy costs (and moreover keep in mind that electricity costs will rise in any catastrophic environment that drives gasoline prices insanely high) that can make up for this increase in fixed costs.

What about other things, like weekend use of the vehicle?  I didn’t cover it here, but everything extrapolates rather cleanly in any case.  Let’s say UD uses another gallon of gas on weekends to visit their parents in the suburbs, run errands, etc.  It doesn’t really impact my entire point.

And what is that point?  There appears to be a diminishing economic return on improving fuel economy beyond 50 MPG.  Note I’m not saying there isn’t some return, just that once the consumer mindset is that spending for gasoline is an insignificant part of their expense structure they will stop caring about further improvements.  Moreover, they will focus even more intensely on fixed costs.

The average age of cars on the road today is over 11 years.  If you own a 50 MPG car today and a decade from now you are offered a 100 MPG car, but at a price way beyond the (inflation adjusted price) of the 50 MPG one you already own, you won’t have economic justification for buying it.  The average age of cars on the road will stretch to 12 years, 14 years, or even more.    To sell cars with MPG beyond 50, they’ll have to improve without increasing fixed costs beyond the improvement in variable costs.

This has implications for all segments of the auto industry.  By 2025 we are going to see non-hybrid gasoline powered midsize cars hitting the 50 EPA MPG mark.  Diesel powered ones will reach that point sooner.  If my economic arguments old true then full hybrids, which have become a significant part of the market, will return to niche status.  And plug-in electrics will have to hit unsubsidized price points that differ little from that of their gasoline-powered cousins to achieve mass market appeal.  Natural Gas will remain mostly a fleet fuel.  And Fuel Cells?  They’ll never get past the curiosity stage.

Is 50 MPG a magic number?  Not exactly.  Government mandates have made it one.  The economic argument I make above could be made with other numbers.  Maybe 40 MPG is the real magic number, maybe 60.  Maybe something else.  I went with 50 because that does represent a sort of speed bump on our current journey, and it’s a round number making back of the envelope calculations easier.  We are there now with hybrids and we’ll be there soon with non-hybrids.  Whatever the exact number, we are approaching the point where consumers are going to feel like fuel costs no longer matter.

Obviously if you can buy a 47 MPG version of the Ford Fusion (i.e., the Hybrid) why does anyone buy the non-hybrid version that does less than half as well in the city and 1/3 worse on the highway?  Currently 88% buy the non-hybrid version.  With a 5 year payback period from the higher fixed cost of the Hybrid most consumers don’t find it a compelling option.

On the other than the Lincoln MKZ variant of the Fusion is priced identically for the hybrid and non-hybrid version.  In the first quarter of 2014 a third of MKZ buyers went for the hybrid.  Why not 100%?  The non-hybrid has more trunk space and better acceleration, but I’d venture skepticism over hybrids is the number one reason.  And perhaps supply limitations.  Lincoln couldn’t supply 100% of its MKZs even if it wanted to, at least not without significant lead time.  So there are plenty of non-hybrids on dealer lots.  But Lincoln has been shifting the production numbers more towards hybrids, and will keep doing so as long as buyers soak them up.

I’ve focused a lot on the mid-size car segment of the market, but even Ford Escape class SUV/Crossovers are expected to approach 50 MPG in 2025.  And with the 2015 F-150 and the 2014 Dodge Ram 1500 EcoDiesel already nearing 30 MPG, my arguments apply over the broad population of “light” vehicles sold in the U.S.

Is there a bottom line here?  Economics drives consumer purchasing behavior, particularly in the long-term.  Yes there are some buyers who will make “poor” economic choices in favor of other priorities, from the philosophic (e.g., environmental concerns) to the esoteric (the Tesla is a really cool car), but they don’t represent the vast majority of buyers.  And because of that I think we are rapidly approaching the point where buyers won’t pay for better fuel economy.

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8 Responses to Is there a point of diminishing return on improving fuel economy?

  1. William C. Scheel says:

    I’ll admit…it didn’t read your blog in detail (well, Hal, it was a bit long for my attention span…so I scanned and maybe missed something…). But, I did reflect on the concept of how we are driven in our purchase decisions to buy vehicles that are cool, but seemingly still affordable…attend to broad economic concerns in our purchase decisions, but maybe only within the bandwidth of an environmental whisper, and buy cars that take us where we need to go in an economical fashion, but not necessarily in an environmentally opportunistic one.

    So, dude, what do you drive? But, more importantly, why do you drive what you drive, and what are you doing (e.g., paying more) to drive something that has the best environmental impact not withstanding other pressing economic concerns?

    Oh, is one of those concerns buying a computer? A cheap car really only has the opportunity cost of a handful of cool computers…and, uh, those few computers are so much more environmentally friendly…right? Let’s get real here. Is a pod of Surface Pro 3s environmentally friendly?

    I’ll admit to having pegged my vehicle-purchase-decision on “all of the above hang-ups “…I drive a Miata. And, my wife drives an Infiniti. Together, we average out to something that still is blatantly pollutant–possibly more so than the equivalent dollars spent on Surface Pro 3s (uh, fully loaded, of course). Why do I doubt that is so?

    I hope you do better than this, Hal…in all your purchases. Please tell me it is so…

    • halberenson says:

      It was way too long! And to be clear, I was explicitly ignoring the environmental aspects. Partially because I don’t feel like that being the debate here, partially because I’m not a believer.

      When it comes to automobile fuel economy I am often motivated by the “traumatic” experience of getting my drivers license just before the 1973 Arab Oil Embargo, so my initial driving experience was sitting in gas lines. And having all my minimum wage income going to pay for gasoline. I have an almost irrational dislike of sending my money to unfriendly oil-producing countries. And my wife has long joked about how I insist on finding the cheapest gas station in the area, but I’ll buy other things without even looking at the price tag. Ah, my head is such a mixed up world :-)

      My primary ride is a Lincoln MKZ Hybrid which is rated at 45 MPG (and gets around 40 in my real life driving situation). I bought it for all kinds of reasons, including just wanting to see what an American car was like these days. Particularly from a technology standpoint. I wanted a midsize luxury car, and figured I might as well get one that was fuel efficient. I was also tired of paying for German cars that were clearly better but outrageously priced. My next most common ride is an old Chevy Suburban that gets 14 MPG on a good day. Well, you can’t really put a Bernese Mountain Dog (and usually its smaller sibling) in an MKZ. Or haul a horse trailer with it. So we’ll always have a large SUV around.

      When it comes to technology, particularly computers, I am neither environmentally nor economically sensitive. I’m purely a conspicuous consumer in this area.

  2. The other considerations are possible disruptions. How do driverless cars fit in? What about Uber and Lyft? The urban dweller may not need a car at all. And the suburban dweller may be able to cut down to one car per family.

    • halberenson says:

      While many cultural shifts can occur over time I suspect the impact of not just ride-sharing (ala UberX) but also car-sharing services will be very mild over the next decade. There are only a few cities in the U.S. where not owning a car is the preferred lifestyle of a significant percentage of the population. Even NYers will do things like own a car and leave it out in the suburbs with family or friends (to avoid city parking charges), then take a train out to the ‘burbs to get it when they are going on a trip.

      As for the one car thing in the suburbs, I’m old enough to recall when that was typical. In fact my Mother, who grew up in NYC, didn’t learn to drive until she found herself in the suburbs with kids. And was very close to a nervous breakdown. And those were the days before the kids were so loaded up with activities. The other day my nieces each had two different after-school activities, then ending up together at a team sport. It took two cars just to get them where they needed to be, and that was after their parents had their individual work commutes.

      But in any case, if people do buy fewer cars it doesn’t change the personal economic arguments about fuel economy much. But it does further suggest that government interference to artificially drive fuel economy higher make no sense. It would make more sense for governments to get the F out of the way for ride-sharing services instead of trying to kill them (as Seattle and some other cities have done) so that these services become more common, convenient, and cheaper.

  3. Bob - Former DECie says:

    I agree with you as far as you went. One possible disruptor is the increasing numbers of baby boomers who have been retiring over the past several years combined with the economy ups and downs over the past decade or so. As more and more baby boomers retire, will they perhaps pay a premium for a hybrid vehicle that gets significantly better city mileage as their driving becomes more city centric? Or will they travel more and be more interested in better highway mileage? Or will they possibly continue into retirement with the same fuel mileage vehicle as they drove pre-retirement? Perhaps the baby boomers will have such small impact that they fall into a niche category? Food for thought.

  4. Brian says:

    Of course, most economics reasoning is based on there being rational consumer. That’s often a stretch. For example… Whenever gas prices get jolted upwards (think, for example, post Katrina where prices went from $2-small to about $4), suddenly people become much more careful to find the cheapest possible price.

    Fitting 10 US gallons into my Fiat 500 is difficult, but does happen occasionally, and it’s a very round number, so let’s use a 10 gallon fill-up as an example. Saving a nickel a gallon on a $2.25 gallon of gas results in a 50 cent saving (about 2.2%). Saving a nickel a gallon on a $4.00 gallon of gas still saves you 50 cents, but this time out of $40.00 instead of out of $22.50 (1.25%).

  5. dbkahn says:

    Surprised you didn’t mention how mpg is actually not the reciprocal we care about. What we really want to know is gallons per mile. Since that is a small number, maybe gallons per 100 miles (which can then easily be converted into $$$ per 100 miles).

    At 5 mpg: 20 gallons per 100 miles

    At 10 mpg: 10 gallons per 100 miles

    At 20 mpg: 5 gallons per 100 miles

    At 40 mpg: 2.5 gallons per 100 miles

    At 80 mpg: 1.25 gallon per 100 miles

    So yes, we are already pretty far down the path of an asymptotically declining curve. But for marketing purposes 80 mpg still sounds way better than 40. One of the many ways in which the wiring of the human brain encourages us to make wonky decisions…

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