We provide empirical evidence that automobile manufacturers use cash incentives to offset how gasoline price fluctuations affect the expected fuel expenses of automobile buyers. Regressions based on a database of incentives over 2003 to 2006 suggest that on average, manufacturers offset 40% of the change in relative fuel costs between vehicles due to gasoline price fluctuations. The results highlight that carbon taxes and emissions trading programs likely would generate substantial substitution within vehicle classes, and studies that ignore manufacturer discounting likely underestimate consumer demand for fuel economy. The results also have implications for the optimal design of feebate programs.

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