When consumers visit their friendly automobile dealer, they encounter a wide variety of options: sedans, SUVs, minis, convertibles, pickups, hybrids, luxury vehicles, and others, as well as the alternatives of new or used vehicles. They also face a choice among gas guzzlers that will incur high running costs, cars with high gas mileage that will cost less over the long term, and everything in between. That choice becomes particularly critical at a time like the present, when gasoline prices show great volatility.

Most previous analyses relating consumers’ choice of cars to gasoline prices have suggested that buyers tend to place a low value on future fuel costs relative to the selling price. But a detailed new study provides a different—and definitive—result: Rather than exhibiting mass myopia about the costs of running their cars, the study finds, the car-buying public reacts in an entirely reasonable fashion to changing prices of gasoline. “People behave consistent with the idea that they are well aware of the gas mileage when they buy,” says Florian Zettelmeyer, a professor of marketing at the Kellogg School of Management. “It’s just not true that American consumers don’t respond to gas prices.”

Figure 1. National average gasoline prices from January 1999 to July 2008 (a) and average fuel efficiency in miles per gallon of available cars by model year (b).

That finding carries a significant message for policymakers intent on finding ways to reduce emissions of carbon dioxide. “We looked at the effect of changing gasoline prices on transactions in car markets,” explains Meghan Busse, an associate professor of management and strategy who carried out the study with Zettelmeyer and Christopher Knittel, now a professor at MIT.

Specifically, Busse says, the study suggests that while any gasoline or carbon tax that affects the price of gasoline would have some impact on the carbon dioxide emissions of new vehicles, that impact would be small. In addition, any such tax would have very different effects on the markets for new and used cars, because of the different structures of those two markets. “We care about that,” she adds, “because designers of environmental policy have to think about the structure of the market into which they’re introducing that policy.”

Three Sources of Information
The researchers reached their conclusions through a thorough analysis of the effect of changes in the price of gasoline on car buyers’ choices of new and used vehicles and the resulting impact of those choices on sales prices. They based their analysis on raw material from three main sources: the Environmental Protection Agency’s data on fuel consumption for different models of automobiles, the Oil Price Information Service’s data on gasoline prices, and a market research firm’s detailed information on car sales. “We have by far the best data anyone has ever had—an enormous sample from 1998 to 2008,” Zettelmeyer says. “We also have excellent gasoline price data at the ZIP code and metropolitan-area level.”

Their information is so comprehensive, Busse adds, that it permits them to study customers’ individual choices. “We have our data from a single data source for both new and used cars, so the data are exactly comparable,” she explains.

Once the researchers had assembled and handled their vast trove of data, the conclusions became evident. “[W]e find a large change in the market shares of new cars when gasoline prices change,” they write in their paper. A $1 increase in the gasoline price leads to a 20.5 percent increase in the market share of cars in the highest quartile of fuel economy and a 23.9 percent decrease in the market share of cars in the lowest fuel-economy quartile.

New vs. Used Cars
The data also show that increases in gasoline prices have a far greater effect on prices in the used car market than on prices of new vehicles. “A $1 increase in the price of gasoline is associated with an increase of $363 in the average price of the most fuel-efficient quartile of cars relative to that of the least fuel-efficient quartile,” the paper notes. “For used cars, the estimated relative price difference is $2,839.”

Those numbers, the research team continues, provide little evidence that car buyers take a short-sighted view about future gasoline costs when they make their purchases. “Indeed,” Zettelmeyer says, “the way consumers react to gas prices is rational in the following sense: They correctly foresee the financial impact when purchasing a new car. The additional price they pay for a new car is approximately in line with the savings they expect going forward in terms of fuel cost—they’re not grossly over- or under-estimating the effect of fuel costs.”

The finding does not surprise Busse. After all, she says, “Gas prices are among the most salient prices in the economy. So consumers have more of a sense of the costs of running their cars than of running appliances in their homes.” In fact, the result touches on a largely neglected area of research. “Little work had been done to look at how the usage costs of a durable good affect demand for that good,” Zettelmeyer says.

Finding Ways to Reduce Emissions
The study also has implications for environmental policy. On the basis of its research, the team states, “we calculate that a gasoline tax or a carbon tax that increased the price of gasoline by $1 would lead to a one-year decrease in U.S. emissions of carbon dioxide of 2.1 million tons from the effect on new car purchases alone.”

Impressive as it may seem, that amount does not indicate that policymakers can reduce automobile emissions of carbon dioxide simply by increasing gasoline taxes. “People change the cars they buy, but not all that much,” Busse explains. “The study tells us that they’re not going to abandon SUVs and pickup trucks entirely if gasoline prices go up. So consumers might be pretty resistant to policies to reduce CO2 emissions through the car avenue.” That means, she continues, that designers of environmental policy should pay attention to market structures and how the markets actually work. “We’re showing you that point for the automobile business,” she says. “Environmental policymakers should think in the same way about other sources of pollution.”

Zettelmeyer points out the message that the study provides for car buyers—and suggests a way that canny consumers can use the results to their advantage. “On average, prices of fuel-inefficient used cars fall a lot and those of fuel-efficient used cars rise a lot when gasoline prices increase,” he says. “So if you drive a lot be aware. But if you drive a little, you should buy a used fuel-inefficient vehicle when the gas price goes up.” Why? As the study shows, you will save significantly on the selling price of the gas guzzler; but because you will drive the car only rarely, the extra cost of gasoline will have only a minor effect on your purse.

Related reading on Kellogg Insight

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And the Poor Get Poorer: The economics of higher global temperatures


Overcoming Shock at the Pump. Economist Meghan Busse says old habits likely to return once gas prices fall (audio)