Winning the Hardware Software Game Winning the Hardware-Software Game - 2nd Edition

Using Game Theory to Optimize the Pace of New Technology Adoption
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How Did We Get Here?

Actual vs. But-For Outcomes

Actual Outcome

But-For Outcome

Other Possible But-For World

Other Questions

Why Didn’t a Competitor Blow the Whistle on VW?

Will VW Users Take Their Cars in for Repair?

Will Users Punish Automobile Manufacturers for Gaming the System?

 

In Part 1 of this analysis, I described the evolution of incentives and actions taken by each set of automobile industry players (Regulators, Users, Manufactures, and Emissions Testers). In this section I examine actual and potential alternative dynamics of the game.

A copy of the full analysis can be downloaded by clicking on the link at the bottom of this blog entry.

 

How Did We Get Here?

Recent investigations of automobile industry practices – mostly as a consequence of the VW scandal – have shown that pretty much all Automobile Manufacturers have been gaming emissions testing procedures by an increasing amount over time, while Regulators have largely condoned their actions. VW’s “defeat device” was clearly illegal and will be sanctioned. However, the other general practices by all industry players, such as vehicle and equipment priming, which have led to actual levels of emissions far above those intended, have long been accepted as legal and standard practice in the industry by both Regulators and Auto Manufacturers.

Brad Plumers published two separate articles in Vox that provide fantastic descriptions of the European Government’s encouragement of diesel-fuel automobiles in Europe: “Europe's love affair with diesel cars has been a disaster”, together with the specifics of VW’s actions: “Volkswagen's appalling clean diesel scandal, explained”.

In a nutshell, after the Oil Crisis of the 1970s, there was a dearth of diesel supply in Europe, relative to demand. In response, European Governments encouraged Auto Manufacturers to develop diesel vehicles. Consequently, diesel technology improved dramatically, moving from slow, noisy, polluting vehicles to quiet, fuel-efficient, zippy cars. European Governments subsequently used concerns over global warming to continue to promote diesel vehicles, since they generate less CO2 than gas vehicles, despite the fact that diesel vehicles emit greater amounts of NOx and PM. Government promotions – to differing extents across different European nations – include:

(i) Establishing “a voluntary CO2 target for vehicles that was basically in line with what diesel technology would be able to meet,”

(ii) Establishing laxer NOx emissions standards for diesel automobiles than those for gasoline, and

(iii) “Cutting taxes on diesel fuel and diesel car purchases to promote sales.”

As a result of these government promotions (especially those in Germany), diesel vehicles increased from 10 percent of new car sales in Europe in 1990 to 60 percent in 2011.

Outside of Europe (Germany), Governments weren’t so encouraging of diesel vehicles. Maximum NOx emissions limits were set – and enforced – to lower levels in the US than in Europe, and the US Government has not subsidized either diesel fuel or diesel vehicles. As a consequence, diesel automobiles penetrations (and levels of NOx pollution) have been much less in the US than in Europe (see Figure 7).

Figure 7

Source: Michel Cames and Eckard Helmers, “Critical evaluation of the European diesel car boom - global comparison, environmental effects and various national strategies”

At the same time, penetration of hybrid and electric vehicles have been much higher in the US than they have been in Europe (Germany) (see Figure 8)

Figure 8

Source: John German, “Hybrid Vehicles: Technology Development and Cost Reduction”

What’s particularly egregious is that over time, Regulators have theoretically been reducing emissions limits on new vehicles. The problem is that Auto Manufacturers have been learning how to increasingly game the test procedures over time. So what has actually happened is that “the gap”,

The Emissions Gap =  Vehicle Emissions Generated in Real World Environment

- Vehicle Emissions Generated During Testing Procedures

has increased. That is, emissions generated during testing procedures – for all types of vehicles, gas, diesel, and hybrid alike – have decreased significantly, while emissions generated in the real world environment have not decreased by nearly as much. Figure 9 illustrates how the gap has increased over time for all vehicle types.

Figure 9

Source: Transport & Environment, “Mind the Gap 2015”

Figure 10 shows that the gap has been much larger for some Auto Manufacturers, namely GM, Daimler, PSA, and VW, than others, such as Toyota, Fiat, and BMW.

Figure 10

Source: Transport & Environment, “Mind the Gap 2015”

In the report “Mind the Gap 2015”, Transport & Environment attributes the widening of the gap to increasing gaming of three different aspects of vehicle testing procedures:

The widening of the gap is not caused by the unrepresentative test cycle (as that has remained unchanged); nor by the way cars are driven (which does not appear to be significantly different). Instead it results from carmakers:

1. Increasingly exploiting loopholes and flexibilities in the testing procedure including “cycle beating” techniques to unfairly reduce emissions during a test

2. Deploying technology on cars that has benefits principally in the test but not on the road

3. Fitting increasing amounts of equipment to cars that is switched off during the test – such as air conditioning

The report allocates the magnitude of the gap across these three factors as presented in Figure 11.

Figure 11

Source: Transport & Environment, “Mind the Gap 2015”

The report also presents a nifty diagram detailing “common ways carmakers manipulate tests for CO2 emissions and fuel economy,” which I provide here as Figure 12.

Figure 12

Source: Transport & Environment, “Mind the Gap 2015”

So we see that there have been several different practices undertaken by European Governments that have enabled Auto Manufacturers to sell millions of vehicles that actually fail to meet standards for fuel efficiency and emissions limits. In the US, where the EPA has been much more stringent than its European counterparts, diesel automobiles have not fared nearly as well.

 

Actual vs. But-For Outcomes

Actual Outcome

In the Actual World,

  • Diesel fuel and diesel automobiles have been subsidized;
  • Enforcement of emissions standards have been lax, and thus levels of emissions – particularly NOx emissions – are greater than they were intended to be;
  • Automobile prices have been cheaper than they would have been, had standards been enforced properly;
  • Subsidization of diesel fuel, diesel vehicles, and lax enforcement of standards has led to greater diesel sales penetrations than there would have been;
  • Greater sales penetrations of diesel vehicles with substandard emissions levels have led to to greater levels of pollution – particularly NOx.

Regulators

Under the past economic environment, Regulators have been able to generate positive public esteem by seemingly supporting increasingly strict mileage and emissions standards. At the same time, Regulators have been condoning the gaming of the testing procedures by Auto Manufacturers, and as a result, Regulators have been able to support (i.e., enhance the profitability of) domestic industries, name Diesel Suppliers and Auto Manufacturers.

Regulators generate revenues through taxes on fuel and progressive taxes on new car sales, where taxes increase with emissions. It’s difficult to tell whether actual fuel usage has been less than or greater than it would have been in the But-For World.

  • Having to meet stricter NOx emissions requirements (in the But-For World) would lead to worse fuel mileage, which would have increased fuel sales and thus fuel tax revenues. So in this respect fuel sales and thus fuel taxes were actually less than they would have been.
  • On the other hand, assuming actual fuel efficiency fell short of the intended standards, then actual fuel sales and thus fuel taxes exceeded what they would have been in the But-For World.

Auto Manufacturers

Under the past economic environment, Auto Manufacturers have been subjected to laxer regulations than they would have been, had they been forced to meet the regulations in real-world driving situations. As a result, they were able to spend fewer resources investing in technology to meet the intended standards, resulting in lower vehicle prices and greater sales quantities.

Users

Under the past economic environment, Users have benefitted from lower-priced vehicles. Expenditures of fuel might have been larger or smaller than they should have been, depending on whether the actual mileage from lower NOx emissions standards ended up being greater than or less than the loss in fuel efficiency they actually experienced. Certainly, Users have been subject to much greater levels of emissions under the actual environment than they would have been had the intended standards been met.

But-For Outcome

In the But-For World,

  • Diesel fuel and diesel automobiles would not have been subsidized;
  • Emissions standards would have been properly enforced;
  • Automobile prices would have been higher, due to the greater investments in technology development that would have been required for vehicles to have met the standards;
  • Without subsidization of diesel vehicles, hybrids would have achieved greater market penetration;
  • Pollution levels – particularly NOx – would have been lower.

Regulators

Under the But-For economic environment, Regulators would have generated the same positive public esteem by actually supporting increasingly strict mileage and emissions standards. However, Regulators would have been less successful at supporting domestic industries, name Diesel Suppliers and Auto Manufacturers.

As described above, It’s difficult to tell whether actual fuel usage has been less than or greater than it would have been in the But-For World.

Auto Manufacturers

Under the But-For economic environment, Auto Manufacturers would have been required to expend greater resources in technology development to achieve automobiles that passed mileage and emissions standards. Many of the diesel automobiles would most likely have been replaced with hybrid technology (see, for example, Aurel Niculescu, “Europe: VW’s competitors could suffer even more from ‘dieselgate’” and Alex Davies, “The Real Winner in the VW Diesel Scandal? Hybrid Cars”)

Users

Users would have paid higher prices for vehicles that actually met emissions standards, but they would have benefitted from cleaner air. Expenditures of fuel might have been larger or smaller than they should have been.

Other Possible But-For World

In the But-For World described above, I assume that Regulators would have enforced the standards as intended and so Auto Manufacturers would have been required to meet stricter standards than they did in the Actual World. However, there is another potential Alternative But-For World. In this Alternative World, Auto Manufacturers, knowing that they would have to actually meet the established standards, might have lobbied for less stringent standards. If such lobbying had been undertaken and had been successful, then lower emissions and mileage standards would have been implemented and enforced.

Assuming Auto Manufacturers would have continued to invest in diesel technology, then the outcomes achieved in this Alternative But-For World would have fallen between those in the Actual and those in the But-For Worlds described above.

Another possibility, though, is that Auto Manufacturers would have decided that the marginally stricter standards in the But-For World were enough to tip the advantage away from diesel and toward hybrid (or some other alternative) technology. In this case, in which Auto Manufacturers would have switched to other technologies, the Alternative But-For World would have approximated the But-For World described above.

 

Other Questions

Why Didn’t a Competitor Blow the Whistle on VW?

It’s clear that all Automobile Manufacturers have been engaged in gaming the system. VW’s defeat device was blatantly illegal, and VW will end up paying a large price, after all the costs of repair, fines, and losses of market cap have been taken into account. However, the gaming of the system in which the other Automobile Manufacturers have been engaged has been legal cheating, so-to-speak, and so the other Automobile Manufacturers will not face any direct punishment (i.e., fines).

What we have is a noncooperative equilibrium in which (i) given the choice between “cheat” and “don’t cheat” and (ii) given that all other Automobile Manufacturers are cheating, then no one Automobile Manufacturer has an incentive to unilaterally not cheat. All that would do would be to place the honest Automobile Manufacturer at a competitive disadvantage relative to the other Automobile Manufacturers vis-à-vis Users.

However, there is another possible option that the Automobile Manufacturers faced: “rat on the competition for cheating.” Why didn’t any of the Automobile Manufacturers take this option?

Considering that each of the Automobile Manufacturers was cheating, the obvious response is that no one of them would rat on the others, because that would simply end up calling attention to his own cheating.

On the hand, there are large differences in the degree of cheating across Automobile Manufacturers. Consider these differences, displayed in Figure 10 (reproduced her for convenience):

Figure 10

Source: Transport & Environment, “Mind the Gap 2015”

From Figure 10, we see that while Toyota was cheating, it was cheating a whole lot less than General Motors or Daimler. So there’s a distinct possibility that Toyota could have come out ahead by making the cheating public. But they didn’t. Why not?

Will VW Users Take Their Cars in for Repair?

Now that it has become known that many of VW’s automobiles don’t meet emissions standards, VW is legally required to issue a recall on affected cars to fix the emissions problems. However, currently, Users are free to ignore the recall without legal repercussions. This begs the question, “Will Users bring their cars in to have them fixed?”

Making the required adjustments to reduce emissions will decrease the cars’ mileage and performance. Presumably, most Users will not readily volunteer to do this. In “If You're A Volkswagen 'Dieselgate' Victim, Will You Cooperate?”Bill Visnic describes the situation beautifully:

My friend and frequent mentor Jim is an owner of a diesel-engine Volkswagen. He got “the letter” this week. Michael Horn, Volkswagen of America CEO, expressed the company’s deepest regrets for violating its customers’ trust in creating engine software to circumvent environmental regulations, will do everything necessary to make it right, kiss your baby and dog, etc.

Jim is unmoved. He doesn’t care about VW’s reasons or its remorse. He bought his diesel-engine Passat for its plucky performance and fuel economy that is almost supernatural in relation to the sedan’s abundant dimensions. He doesn’t intend to backtrack on that just to permit VW to make it right – because making it right, Jim reckons, is going to involve concessions from him, too.

He didn’t buy in for that.

So then what are the options?

One option, proffered by Visnic, is for VW to pay Users to bring their cars in for repair:

An uncomfortable question for VW and regulators is just how many diesel-car owners hold the same position as Jim. Since it’s probable not many will gladly get in line to have their car’s performance whittled down, VW may have to provide extraordinary inducements just for the privilege of spending what’s likely to be hundreds, if not thousands of dollars to fix each of the high-emitting diesels.

As an aside, VW just announced it would provide Users with vouchers granting them $1,000 in gift cards and vouchers (see for example, Tom Krishner, “VW diesel owners to get $1,000 in gift cards and vouchers”). But this was a pure show of good faith on VW’s part, not contingent on Users bringing in their cars to be fixed.

Another option is for Regulators to compel Users to have their cars repaired by refusing to renew their registrations otherwise. While probably effective, this would not be a good public relations move.

Also possible is for VW to buy back the “defective” cars from Users. Presumably, this would be a last resort, since the cost to VW would be substantial. According to Tom Krishner, “Lawsuits could force VW to buy back cheating diesels”:

The 482,000 cars are worth an average of $14,466, ranging from $8,409 for a 2009 Jetta to $21,474 for a 2015 Passat, according to Kelley Blue Book. At the average resale value, VW could be forced to pay more than $6.9 billion to repurchase the cars. That amount would cover most of the $7.3 billion that VW has set aside for the emissions scandal.

An alternative solution posed by a colleague of mine would be for VW to forego the recall and repairs and simply pay for the excess emissions associated with its automobiles. Users are getting much better mileage without the pollution controls, which means they’re using les fuel and emitting less CO2. However, they’re emitting more NOx, reportedly “up to 40 times more than allowed” (see, for example, Geoffrey Mohan and Ben Welsh, “Q&A How much pollution did VW's emissions cheating create?” The “40 times more” figure is an absolute upper bound on excess emissions, since emissions vary with speed and driving conditions. According to my calculations (see Figure 13), the cost of the excess emissions, valued at the market price of NOx, is $51 per vehicle over the expected life of the car. Estimates put the cost to VW of repairing recalled vehicles at about $2,500 for parts and, say, $2,000 for labor (see Aaron Cole, “Here’s What It Might Cost To Fix Each 2.0 TDI Volkswagen”). Paying the $51 would sure be a whole lot easier and cheaper than either the repair or the buy-back.

Figure 13

Will Users Punish Automobile Manufacturers for Gaming the System?

When news of the VW scandal broke, VW’s stock price took a large hit. In the aftermath of the announcement, when it became clear that all Auto Manufacturers have been gaming the system, the other car companies also suffered decreases in stock prices.

Drops in stock price reflect expected drops in future profitability, which could be due to either

  • Higher expected future costs: higher costs would be expected if Auto Manufacturers were forced to adhere to stricter emissions limits;
  • Lower sales volumes: lower sales volumes would result from higher vehicle prices associated with having to develop lower emissions vehicles.
  • Losses in goodwill (brand name reputation): losses in goodwill would result from punishment for cheating.

However, it appears (see Figure 14) that the stock price hits suffered by the Auto Manufacturers – excluding VW – have already recovered. This suggests that Auto Manufacturers will not be punished for gaming the system.

Figure 14

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