Quality-based price discrimination and tax incidence: evidence from gasoline and diesel cars.

The existing tax policies toward gasoline and diesel cars in European countries provide a unique opportunity to analyze quality-based price discrimination and the implied tax incidence. In my econometric framework, consumers choose the type of engine based on their annual mileage; prices are set by the manufacturers. The relative pricing of gasoline and diesel cars appears to be consistent with monopolistic price discrimination, effectively segmenting low-mileage from high-mileage consumers. On average, about 75% to 90% of the price differentials between gasoline and diesel cars can be explained by markup differences. I draw implications for the effectiveness and the revenue effects of tax policy.

1. Introduction

Price discrimination based on willingness to pay for quality has been studied extensively in the theoretical literature. Mussa and Rosen (1978) show how a monopolist can extract higher profit margins from consumers with a higher willingness to pay for quality by offering a wide product line of price-quality combinations. When several firms compete, the feasibility and nature of quality-based price discrimination is less well understood. It depends on the precise pattern of competitive interaction, and no general results are available. (1) At the same time, efforts to quantify the empirical importance of price-discriminating practices have been limited. The problem is, of course, that the observed price differentials between high-quality and low-quality variants may stem from either cost or markup differences.

The European car market presents a unique opportunity to empirically analyze quality-based price discrimination. In most European countries, car buyers have a choice of two engine types: gasoline and diesel. The diesel engine has a higher "quality" in the sense that it consumes less fuel per mile and requires less expensive fuel due to a favorable tax treatment. Consumers differ in their willingness to pay for this quality aspect, since they are heterogeneous in their annual mileage. As a result, manufacturers may consider a price-discriminating strategy by charging different profit markups on the gasoline and the diesel variants to exploit the consumer mileage heterogeneity.

I develop an econometric model of demand and pricing for gasoline and diesel cars. The demand model allows consumers to be heterogeneous in their willingness to pay for the fuel cost per mile, while it restricts consumers to be homogeneous in their valuation for other quality differences between gasoline and diesel engines. The model predicts average mileages for gasoline and diesel consumers that are consistent with prior information. In particular, the average mileages of gasoline consumers are substantially below those of diesel consumers. The dominant engine characteristic for which consumers have heterogeneous preferences therefore appears to be the fuel cost per mile. Preferences for the other engine characteristics appear to be reasonably homogeneous as a first approximation.

The pricing model investigates whether firms exploit this preference heterogeneity for fuel costs by charging higher markups on diesel cars. I decompose the observed price differentials between gasoline and diesel cars into their cost and markup components. The estimates demonstrate that the price differentials are best explained by price discrimination of a monopolistic type. On average, about 75% to 90% of the price premium to be paid for a diesel car can be attributed to price discrimination between high--and low-mileage consumers; the remaining part follows from higher costs due to differences in engine specifications. These results empirically demonstrate the feasibility and the importance of quality-based price discrimination in the presence of competition. The results have implications for the effectiveness of fuel tax and car tax policy. For example, the estimated demand effect of an increase in the diesel fuel tax is reduced by 50% if one accounts for monopolistic price responses to tax changes. The revenue effects are also affected, but to a lesser extent.

As noted above, there is very little econometric evidence on quality-based price discrimination. Shepard (1991) analyzes a market in which firms differ in their ability to price discriminate, but presumably not (much) in their cost of production. Observed differences between firms in price differentials may then be attributed to markups, i.e., price discrimination. (2) Unlike Shepard's application, I have no prior information on costs. I instead infer the presence of price discrimination from the structural model of conduct that is found to best fit the data. Leslie (1999) considers various types of price discrimination for a Broadway play, including price discrimination based on different seat qualities. He starts by estimating the demand system and computes the prices as predicted by the current industry circumstances. He then investigates how prices would change if the firm had more flexibility in setting the price menu. (3)

Research on demand and pricing in the automobile market has received considerable attention in recent years. Most contributions ignore the issue of quality-based price discrimination by limiting attention to base model cars. The focus is instead on the nature of product differentiation and competition between different car models. See the contributions by Bresnahan (1981, 1987), Berry, Levinsohn, and Pakes (1995, 1999), Feenstra and Levinsohn (1995), Goldberg (1995), Petrin (forthcoming), and Sudhir (2001) for the U.S. market.(4) Regarding the European car market, Verboven (1996) and Goldberg and Verboven (2001) provide evidence of international price discrimination. This is price discrimination of the third degree, and it is achieved by the manufacturers' strategies to prevent cross-border consumer (or parallel importer) trade. The present article may be seen as reinforcing the evidence that firms in a seemingly competitive market succeed in price discrimination, not only of the third-degree but also of the second-degree type, by profitably segmenting consumers with a low annual mileage from those with a high annual mileage.

Detailed econometric evidence is available on price elasticities of demand for fuel. Goodwin (1992) and Oum, Waters, and Yong (1992) provide a survey of this literature. The considerable amount of empirical research can be explained by the strong interest from a public-policy taxation perspective. A distinction is usually made between short-term and long-term fuel price elasticities. Short-term elasticities measure fuel demand effects keeping the size and structure of the vehicle stock fixed. Long-term elasticities take into account that fuel price changes induce (i) consumers to substitute to other products and (ii) firms to develop new products. (5) A robust finding is that the long-term fuel price elasticities are substantially higher than the short-term elasticities. The results of the present article imply that the long-term fuel price elasticities may be overestimated if one does not properly account for the observed tax incidence by the car manufacturers in response to fuel price changes. (6)

The outline of the article is as follows. Section 2 describes the market for gasoline and diesel cars in three European countries: Belgium, France, and Italy. Section 3 introduces the demand model, while Section 4 considers pricing. Section 5 discusses identification and estimation of the model. The empirical results are presented in Section 6. Finally, Section 7 concludes.

2. The market for gasoline and diesel cars in Europe

The vast majority of automobile engines in Europe are fuelled with either gasoline or diesel petroleum. (7) Diesel-engine automobiles quickly gained popularity in Europe during the 1970s, stimulated by favorable tax treatment and subsequent technological improvements. In recent years, the choice between a gasoline or a diesel car has become one of the key elements in the European consumer's car-purchasing decision.

To introduce the questions addressed in this article, I shall first cover technology, taxation, pricing, and demand. This discussion is based on a dataset collected for three European countries, summarized in Tables 1 and 2. The data consist of sales, list prices, taxes, and technical characteristics of 41 pairs of automobile models in Belgium, France, and Italy during the period 1991-1994. These data are supplemented with information on the distribution of annual car mileage. Data on list prices (including value-added taxes) and technical characteristics come from the following weekly retail catalogues (one of the August issues): De Autogids (Belgium), l'Automobile Magazine (France), and Quattroruote (Italy). Sales data come from publications on new car registrations by the Nationaal Instituut voor Statistiek (Belgium), l'Argus de l'Automobile et Locomotions (France), and A.C.I. (Italy). Average annual gasoline and diesel fuel prices, for all three countries, are taken from l'Argus de l'Automobile et Locomotions. Data on the distribution of mileage, organized in categories of several principal characteristics (weight and horsepower), come from the industry associations A.C.E.A., F.E.B.I.A.C., and T.R.I., and from survey data by De Borger (1987).