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Case 1: Benefit-Cost Analysis of Honda Civic Hybrid Sedan

Case 1: Benefit-Cost Analysis of Honda Civic Hybrid Sedan
 
BACKGROUND
 
In 2003, Honda released the first hybrid version of its popular Honda Civic. Since then, many states and the U.S. federal government have applied incentives to encourage individuals to purchase hybrid vehicles. The 2005 Energy Policy Act granted individuals who purchased new hybrid vehicles a tax credit, which depends on the fuel economy of the model (miles per gallon, or mpg). This tax credit expired December 31, 2009. But there have been calls in Congress to renew it. Many states also offer their own incentives programs.
 
Is subsidizing hybrids a wise use of public resources? This is the question this case is designed to answer.  To answer this question, there are two related issues to consider.
 
First, taking into account society’s perspective, the question to consider is whether the additional (incremental) benefits of driving a hybrid are greater than the additional (incremental) costs, compared to the non-hybrid model. Fundamentally, this question boils down to whether the value of the fuel savings from driving the hybrid are larger than the increased technology cost of the hybrid. The value of fuel savings includes the value of conserving a scarce resource – energy– but also the value of avoiding the social costs associated with energy usage, such as CO2 emissions, local air pollution, and the risks to national security associated with importing oil. Consumers deciding whether to buy hybrids are aware of the fuel savings benefits that they will realize if they buy and drive hybrids, and will consider the expected value of these fuel savings in their purchase decision.  However, the consumer’s computation of fuel savings benefits will differ from the societal perspective, because the fuel prices consumers face are distorted by fuel taxes.  So the “price signals” consumers face about the value of fuel savings are likely to differ from the shadow price of fuel savings measured from a societal perspective. And of course, consumers are not fully aware of the value of the reduced global warming risks, benefits to reducing local air pollution, or reducing national security risks, because these benefits are diffuse and distributed to everyone. Thus, consumers will not fully consider these benefits in their private purchase decision.
 
The increased technology costs are in the form of the additional costs for the hybrid drive train, which adds to the conventional system:  (1) an electric motor (2) a large capacity battery and (3) the power electronics that link these components together.  The price consumers pay for Honda civic hybrid will actually be higher than these costs, because there is 7% sales tax imposed on the purchase of hybrids. The societal analysis will “shadow price” the technology cost of producing Honda civic hybrids as the price consumer’s pay less the sales tax.
 
As always, the net-value from a societal perspective can be obtained in two equally good ways. First, by summing the net effect of driving a hybrid on all of the “stakeholders.”  If the net-effects are positive, the project passes the Kaldor-Hicks standard.
 
The stakeholders in this situation can be aggregated to the following four groups:
 

  • The hybrid user;

 

  • State governments, who receive additional sales tax revenue from higher hybrid sales prices, but also lose fuel tax revenue from improved hybrid fuel economy;

 

  • The federal government, which loses fuel tax revenue;
  • “the public” who gains the “societal” or external benefits of hybrid use; that is, the reduced air pollution, carbon dioxide emissions, and the value of reduced oil imports.

 
Summing the net effects on (1)-(4) will give the same result as directly comparing the shadow-priced value of the fuel savings against the costs – the second method for determining economic efficiency.
 
The complete picture is shown in Table 1.  Summing the net-stakeholder effects in the bottom row of the tableau produces the societal net benefit in the rightmost bottom cell, B1+B2-C1. This is the after-tax value of fuel savings plus environmental benefits less the technology costs.  You can see the same result just by comparing the benefits against the cost in the right most column of the tableau.
 
Note that the column for the “Buyer of the Honda Civic” shows the private perspective from the purchase of the Honda Hybrid. This column represents the financial returns and losses to the buyer of  a Honda hybrid. Comparing this column to the right-most column of the tableau allows  you to see how the private buyer perspective differs from the societal perspective.  As mentioned above, there are two differences between these perspectives. First, there is the added benefits to society of avoided pollution and other external costs of fuel use, which the private user themselves do not experience, but society gains (B2). Hence, the private buyer doesn’t take into account this external benefit when they purchase the hybrid. Secondly, part of the hybrid buyer’s financial gain in avoiding fuel expenses is not a net gain from the societal perspective. That’s because fuel tax savings of the hybrid driver  (T2+T3) are lost to governments, i.e., to states (-T2) and the federal government (-T3). In short, what is the buyers’ gain is another stakeholders loss, so, as financial transfers, these effects cancel to zero from a societal perspective.
 
Similarly, the additional financial loss to the buyer of paying a sales tax on hybrids (-T1) is not a net-societal loss, because another stakeholder –the state in this case, collects the sales tax (T1). Again, the loss to one stakeholder is counterbalanced by the gain to another, so these gains and losses net to zero from the societal perspective.
 
The first task then, is to complete Table 1 with actual values, and to see if B1+B2-C1 in the far right-hand corner is positive or negative.
 
If it is negative, it does not make sense for the government to promote hybrid usage, if the Kaldor-Hicks standard (Potential Pareto Criteria) is the decision-making standard.
 
If it is positive, we then have to look at the “Buyer of the Honda Hybrid” net result. If it is privately profitable to  buy hybrid Honda Civics without assistance, then the argument for providing subsidies is diminished – whatever the merits of driving hybrids. Why subsidize people to buy Honda hybrids if they are going to buy them anyway? If, however,   private hybrid buyers are taking a financial loss and yet driving hybrids has positive societal benefits, then it makes sense to offer a subsidy to promote the socially desirable behavior.  Note that such a subsidy is a pure financial transfer from the societal perspective – a gain to the hybrid driver, and a loss of equal amount to the government. So subsidizing hybrid users has no net effect from the societal perspective. But from an equity point of view, it wouldn’t make sense to transfer tax payer money to hybrid drivers, if there wasn’t some larger societal purpose to do so.
 
Note: As shown in Table 1 and discussed above, the computation of the buyer’s financial effect should not include tax credits.  It is necessary to compute the impact on the buyer without the tax credit, to see whether or not a tax credit is needed.
 
The impact on state and federal fuel tax collections is also policy relevant. States and the federal government rely on fuel tax receipts to fund transportation investments. Growing fuel economy could reduce overall tax receipts, and reduce funds for transportation infrastructure.  “Erosion” of fuel tax revenue from greater fuel economy has worried some states enough to consider switching the tax base from fuel consumption to mileage.  See the state of Oregon’s experiments in this regard: http://www.terrapass.com/blog/posts/oregons-successful-mileage-tax-experiment
 
In short, it is of interest to compute the impact of hybrid driving on the receipts of state and federal tax revenues.
 
THE ASSIGNMENT
 
Your tasks are as follows:

  • produce six tables like table 1 based on present value computations for the following scenarios;

 
Scenario 1:  10,000 miles per year driving, gasoline 2.50 per gal
Scenario 2:  10,000 miles per year driving, gasoline 3.50 per gal
Scenario 3:  10,000 miles per year driving, gasoline 4.50 per gal
 
Scenario 4:  20,000 miles per year driving, gasoline 2.50 per gal
Scenario 5:  20,000 miles per year driving, gasoline 3.50 per gal
Scenario 6:  20,000 miles per year driving, gasoline 4.50 per gal
 

  • Write a no-longer-than 4 page double-space memorandum (this page length EXCLUDES ANY TABLES YOU MIGHT INCLUDE) which describes the analysis, presents the results, and then makes a recommendation whether or not Congress should renew tax credits for hybrids. Your memo should be broken down explicitly into sections with bolded headers as follows:

 
Introduction
 
Analysis Method and Assumptions
 
Results
 
Policy Recommendation
 
See memo for Cincinnati Vehicle Emissions Inspections case as a model for this kind of policy/decision memo.
 
 
GROUND RULES AND INSTRUCTIONS
 

  • You are encouraged to form working groups and collaborate on the analysis.

 

  • You must write up the memo yourself.

 

  • To complete the assignment, post two things (under Assignment 2) on oncourse:

 
* your memo in Word, which should include the six tables as appendices;
* spreadsheet showing the six computed tables, with their backup computations. Again, link  KHTs to source computations to facilitate computations of the different permutations (for miles/fuel price);
 
(4)  Do the analysis from the end of 2011 perspective. Thus, for discounting purposes, period zero is 2011, period 1 is 2012, etc.
 
(5) Let me know if you have questions
 
TABLES

Table 1: Kaldor-Hicks Tableau for Honda Hybrid Civic Buyer of Honda Hybrid State governments Federal Government Public receiving environmental and national security  benefits  of fuel savings Net Society
Benefits          
  Pre-tax value of fuel savings from driving hybrids B1       B1
Environmental and other external benefits       B2 B2
Transfer payments        
State  sales taxes -T1 +T1     0
State fuels taxes +T2 -T2     0
Federal fuel taxes +T3   -T3  
Costs        
Technology Cost differential -C1       -C1
Net B1+T2+T3-(T1+C1) T1-T2 -T3 B2 B1+B2-C1

 
 
Note: B1+T2+T3=consumer fuel expenditure savings, which equals avoided fuel tax payments, plus net-of-tax fuel expenditures.
 
The retail price differential of the hybrid (before sales tax) is C1.
The after sales-tax price differential is T1+C1.
 
So the net for consumers is the difference between avoided fuel expenses (B1+T2+T3) less the incremental price of hybrids (T1+C1).
 
All figures in the  table are discounted present values.
 
 
 

Table 2: Basic Data on Two Alternatives 2011 Hybrid Civic Sedan
(lowest end model)
2011 Conventional  Honda Civic Sedan
(lowest end model)
Recommended Sticker Price (Does not include sales tax) $23800 $15655
Mpg  city 40 26
Mpg  highway 45 34

 

Table 3: Basic financial parameters which don’t vary  
Discount rate .07
State sales on car purchases .07 (Indiana)
State fuels tax .18 cents per gallon (Indiana)
Federal fuels tax .184 cents per gallon

 
 

Table 4: Fuel Price Assumptions  
High 4.5  per gallon
Medium 3.5  per gallon
Low 2.5 per gallon

 
Other Basic Assumptions
 

  • Operation and maintenance (O&M) costs: no difference between options

 

  • Insurance costs: no difference between options.

 

  • Average vehicle life: 15 years/no salvage value at end: no difference between options (from our perspective, does not matter whether the car is sold, and resold during this period. Simplest to treat it as a single ownership over the whole period)

 

  • Driving behavior: assume no difference between options:

 
Low: 10,000 miles per year
 
High: 20,000 miles per year
 
Equal mix of city and highway driving
 
 
 
 
 
 
 
Table 5: Societal Costs of Automobile Usage
 

Fuel-Related
Global Warming $.06 per gallon
National Security $.12 per gallon
Local Pollution $.20 cents per gallon*
Total $.38 cents per gallon
Mileage related**
Congestion $1.05 cents per mile**
Accidents $.63 cents per mile**

 
*Note: this was listed as .42 cents per mile. I took about half of this figure, because local auto emissions are controlled by catalytic converters, so reducing fuel consumption doesn’t necessarily reduce pollution that much. And these external costs are at least partially related to miles driven, which is we are assuming is the same for both vehicles
 
**I have included mileage related externalities just to show the external costs of driving beyond what the driver themselves imposes. However, YOU SHOULD NOT INCLUDE THESE THE ANALYSIS. REASON? WE’RE ASSUMING THE MILES DRIVEN BY BOTH HYBRIDS AND NONHYBRIDS ARE THE SAME. SO THESE EXTERNAL COSTS DON’T VARY ACROSS OPTIONS.
Source: Parry, I. W. H., Walls, M. & Harrington, W. (2007). Automobile externalities and policies. Journal of Economic Literature, XLV, 373–399.
 
NOTE ABOUT PARAMETER VALUES IN U.S. AND EUROPE.
 

  • FUEL TAXES. MUCH HIGHER IN EUROPE. BUT BECAUSE FUEL TAXES ARE TRANSFERS, THIS DOES NOT AFFECT NET-BENEFITS, I.E., THE BOTTOM LINE NET-EFFECT IN THE BOTTOM RIGHT HAND CELL OF THE TABLEAU. HOWEVER, FUEL TAXES WILL GREATLY AFFECT THE PRIVATE GAIN TO DRIVING HONDA CIVIC HYBRIDS (MUCH HIGHER IN EUROPE THAN COMPUTED IN THIS MEMO) AND THE LOSSES IN TAX RECEIPTS TO THE GOVERNMENT. IN SHORT, THE DIFFERENCES IN TAX RATES WILL HAVE A SIGNIFICANT DISTRIBUTIONAL EFFECTS, BUT NOT ANY NET EFFICIENCY EFFECT.

 

  • DISCOUNT RATES. SEE TABLES IN ASSIGNMENT 1 FOR HOW DISCOUNT RATES IN EUROPE COMPARE WITH THOSE IN THE U.S.

 

  • SALES TAXES. NOT SURE EXACTLY THE COMPARISON. BUT SINCE EUROPE HAS VALUE ADDED (VAT TAXES), THERE ARE LIKELY TO BE ADDITIONAL TAXES ON THE INPUT SIDE NOT REFLECTED IN THE ABOVE ANALYSIS.

 

  • GLOBAL WARMING EFFECTS. BY DEFINITION, THE SAME.

 

  • VALUE OF REDUCING IMPORTS. HIGHLY VARIABLE BY COUNTRY IN EUROPE. NORWAY IS A NET OIL EXPORTER, AND IS NOT CONCERNED ABOUT IMPORTS. GERMANY IS A NET OIL-IMPORTER.

 

  • LOCAL AIR QUALITY EFFECTS. LIKELY TO BE PRETTY MUCH THE SAME AS IN THE U.S. IN THE MORE DEVELOPED EU STATES, I.E., THE U.K, NORTHERN EUROPE, FRANCE AND SPAIN. AIR QUALITY BENEFITS FROM REDUCING FUEL USE ARE LIKELY TO BE GREATER FOR NEWER EU COUNTRIES IN EASTERN EUROPE (POLAND/HUNGARY) AND SOUTHERN EUROPE (PORTUGAL, SOUTHERN ITALY, GREECE). AIR QUALITY STANDARDS THERE HAVE NOT BEEN UPGRADED TO THE LEVEL OF THE ADVANCED EU STATES.
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