Volkwagen Scandal and Microeconomics

¶ … tells that Volkswagen has been found, and admitted to, cheating on emissions tests for its vehicles. That cheating had shown that diesel was cleaner than unleaded, which in turn resulted in favorable tax treatment for diesel. This in turn increased the demand for diesel products, as they were cost-competitive versus gasoline cars. With the admission that Volkswagen falsified these tests, leading to the conclusion that unleaded gasoline is the cleaner of the two fuels, there are significant implications including the possible reversal of tax policy in the EU away from favoring diesel as a fuel source for automobiles.

The market for fuels is typically subject to various regulations, and emissions are one of the regulations that govern this market. Tax policy is based on multiple factors but in Europe in particular tax policy is based on the desire to control emissions. Tax policy moves the fuel market out of equilibrium, and in this case tax policy was moved to favor diesel. This in turn encouraged the sale of diesel vehicles, as these vehicles were cheaper for consumers to operate. Thus, diesel vehicles were better value to European consumers, and ultimately captured a very high market share.

Should tax policy favoring diesel be reversed, this will have an impact on the long-run demand for diesel vehicles. Short run demand may also change. While the market for diesel will not change in the short run, the market for diesel-powered vehicles should change quickly. As consumers realize that gasoline vehicles are cheaper in the long run, they are more likely to demand such vehicles, thereby decreasing aggregate demand for diesel vehicles.

While aggregate demand is likely to change relatively quickly, because the cost of owning a vehicle will change as soon as the tax policy changes are implemented -- and likely the consumer response will be even faster, just knowing that the changes are pending -- production of vehicles cannot change as quickly. There is significant lead time for new vehicle design and production. Some producers will therefore be able to shift production to gasoline vehicles, but the process will take time. Other producers, such as Volkswagen, are focused on diesel engines, and therefore are unlikely to switch to gasoline engines even in the long run. In the face of a decline in aggregate demand, Volkswagen is likely to need another strategic response.

Volkswagen enjoyed comparative advantage with its diesel vehicles under the old tax regime. In order to retain that advantage they will need to petition government to leave the present tax structure unaltered. This is unlikely, since Volkswagen's influence was not the cause of the tax policy, but rather the need to implement strict environmental controls was the driving factor behind the tax policy and that has not changed. Thus, Volkswagen will lose its advantage in the marketplace. The company will need to respond by offering comparative advantage in other areas. The simplest approach is to lower the price, which is a natural response to a decline in aggregate demand. The new equilibrium point in the market for diesel vehicles is going to be a lower AD point and a lower AS point. Volkswagen can, by lowering its price, set that equilibrium point a little higher, allowing it to maintain some of the AS, because the lower price will spur an increase in AD.