Economists generally argue that if an activity like pollution has an externality, the optimal way to deal with it is via direct taxation of the activity. This is why economists often support dealing with the pollution and other externalities of driving a car via a gasoline tax. Fuel economy standards and other regulatory kludges are unnecessary and inefficient in comparison. A common retort to this is that consumers don’t actually consider gas prices when making their auto purchases, and so fuel efficiency is undervalued by the market and a gas tax won’t actually lead to an efficient level of fuel efficient vehicles. Under this reasoning, CAFE standards are not a second best policy to gas taxes, but are a good policy.
New NBER research from Sallee, Fan, and West suggests that this common defense of CAFE standards is incorrect. Instead, they find that consumers do fully consider the fuel efficiency savings when making auto purchases.
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