relevance to the issue of government intervention. If the market is functioning perfectly, and all costs are reflected in the marketplace, then government intervention will always reduce economic efficiency. But if the market fails to perform as microeconomic theory would hold, or if significant costs or benefits are not reflected in market prices for energy or energy services, then carefully designed government policies can improve economic efficiency.

Thus, a necessary condition for government intervention in the market is the existence of significant market failures or externalities. These can be identified either empirically--through studies showing that the market does not produce the results consistent with economic theory--or preferably by identifying specific mechanisms of market failure.

Next, the sufficient condition for government intervention is that the benefits of intervention must exceed its direct and indirect costs. In the case of standards, not only should the benefits exceed the costs, but the benefits of a particular level of standards should be higher than alternative levels, and the benefits of standards as a policy must be greater than the benefits of alternative policies that could achieve similar results.

The quantitative analysis of market failures, and the cost-benefit analysis of alternative policies intended to address those failures, would make use of the National Energy Modeling System (NEMS).

Analytical Requirements

The first step is to analyze market failures that may be affecting the choice of automotive fuel economy. The existence of market failures would explain why there are societally cost-effective improvements in energy efficiency that are not currently being exploited.

The analysis would attempt to identify all possible externalities and market failures with a bearing on the efficiency issue, and determine the best ways of rectifying these failures. This analysis will develop the arguments as to whether government mandated efficiency standards will best address those market failures. Efficiency standards may represent a “second-best” approach to these market failures, in which case the infeasibility of first-best approaches must be established. Plausible externalities to be examined include:

  1. Presence of market power over the world oil price;

  2. Degradation of environmental resources that are not factored into private consumption and production decisions;

  3. The public good aspects of investment in research and development (R&D) that would cause the private sector to underinvest in more efficient technology;

  4. Possible differences between social and private discount rates; and



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