Tuesday, July 15, 2008

The Ratings Game

I read some interesting articles today that argued that the metric of miles per gallon (MPG) should be abandoned for something that better represents the actual savings in gas when increasing MPG.

The original idea can be found here at Treehugger.

A follow up article on Ecogeek takes it a bit further.

The argument is a tricky one, because it shows that mpg is not a linear function, it is curvilinear. Increasing mpg from 15 to 20 saves as much gas as going from 30 to 60. While it's an interesting observation, I have a shocking announcement...

It doesn't matter.

Wait, what? Doesn't fuel efficiency matter to you, Dan? Well, yes it does, but in the grand scheme of economics, miles per gallon is not as much a driving factor in car purchases as you might think. (Yes, pun intended.) As much as people whine and moan about the high cost of gas, and even with the recent popularity of hybrid vehicles, the annual expense of gas is still a small percentage of buying and operating a vehicle. Allow me to demonstrate using the numbers that the two above articles are using. We'll also assume that the average person drives 12,000 miles per year (I googled that) and that the cost of gas is $4.50 a gallon (assuming it doesn't skyrocket further).

12,000 miles / 15 mpg * $4.50/gal = $3,600

12,000 miles / 20 mpg * $4.50/gal = $2,700

12,000 miles / 30 mpg * $4.50/gal = $1,800

12,000 miles / 35 mpg * $4.50/gal = $1,542

12,000 miles / 60 mpg * $4.50/gal = $900

Going from 15 to 20mpg saves you $900 a year in gas costs. But going from 30 to 35mpg only saves $258. You have to go from 30 to 60 to get another $900. Yes, more savings always sounds better, but is it worth it? If the extra cost (known as a price premium) of going from 30 to 35mpg is $2850, it will take 10 years to recoup the price premium in gas savings. If the same price premium of $2850 was applied to the car when the mpg went from 15 to 20mpg, it would still take 2.8 years to recoup the price premium in gas savings. This kind of diminishing returns actually does not promote buyers to purchase cars with higher and higher efficiency. There is actually a breaking point where customers will refuse to spend more to gain mpg.

According to the Federal Trade Commission, the average price of a new car is $28400. For the sake of our math, let's make it $28500. That means in our above example, that a price premium of only 10% to gain 5mpg is, in most cases, hardly worth it. If a user looks at two cars, all other features being equal, will they purchase the car that does 30mpg and costs $28400 or will they purchase the car that gets 35mpg but costs $31250? Are they willing to wait 10 years to break even on the more expensive but more efficient car? When you also consider that the selling price also affects your taxes and insurance, the cheaper car becomes a no-brainer.

This is why most cars don't have more than 30 mpg. As much as people lament the high cost of gas, it's still cheaper in the long run to buy a slightly less efficient car. Until the benefit of gas savings overcomes the price premium of the car, consumers will keep buying gas guzzlers. And the only way that is going to happen is if the cost of gas keeps going up!

Of course, these aren't the only things that affect user's reasons for buying cars, but I wrote this to show that advocates of changing the MPG metric or people who wish that all cars could somehow be made more efficient are simply wasting their breath. Yes, we want a greener planet, but Average Joe is not likely to pay for it out of the goodness of his heart. Playing games with numbers and metrics is not the answer and mandating CAFE standards won't work either because the economics don't work that way. What's needed is real innovation that reduces the cost of producing more fuel efficient vehicles. Whether that happens incrementally or all at once will be decided by those who have the most to gain from it.

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