Assessing Effects of

Government Regulations on

Manufacturers

Discussion with

Department of Energy

April 6, 1994

Arthur D. Little, Inc. on

behalf of Air Conditioning

and Refrigeration Institute,

Association of Home

Appliance Manufacturers,

Gas Appliance

Manufacturers Association

Reference: 44856

EE-RM-90-201 COMMENT OOF12

Assessing Effects of 

Government Regulations on 

Manufacturers 

Discussion with 

Department of Energy 

April 6, 1994 

Arthur D. Little, Inc. on 

behalf of Air Conditioning 

and Refrigeration Institute, 

Association of Home 

Appliance Manufacturers, 

Gas Appliance 

Manufacturers Association 

Reference: 44856 
Situation

Department of Energy requires a method to assess effects of

appliance efficiency regulations on manufacturers.

Understand financial impacts of regulations

Utilize currently accepted theory/modeling techniques

Currently based on Manufacturers Impact Model (MIM)

developed by Lawrence Berkeley Laboratories (LBL)

ES44856aq033094

EE-RM-90-201 COMMENT OOF12

Situation 

Department of Energy requires a method to assess effects of 

appliance efficiency regulations on manufacturers. 

Understand financial impacts of regulations 

Utilize currently accepted theory/modeling techniques 

Currently based on Manufacturers Impact Model (MIM) 

developed by Lawrence Berkeley Laboratories (LBL) 

ES44856aq033094 
Situation

An appropriate model must be credible, usable, accurate and meet

additional criteria requested by DOE.

Credible

Usable

Accurate

DOE criteria

ArtJur D Little

• Measure major forces impacting effects on manufacturers

• Account for all significant effects on manufacturers

• Be based on sound underlying principles

• Be verifiable and understandable to all major users

• Utilize readily available data

• Use reasonable, predictable assumptions

• Provide clear, understandable output

• Produce accurate forecasts of future market behavior

• Result in correct and repeatable impact measures

• Contain predictive capability for prices, quantities, etc.

ES44856aq033094 2

EE-RM-90-201 COMMENT OOF12

Situation 

An appropriate model must be credible, usable, accurate and meet 

additional criteria requested by DOE. 

Credible 

• Measure major forces impacting effects on manufacturers 

• Account for all significant effects on manufacturers 

• Be based on sound underlying principles 

• Be verifiable and understandable to all major users 

• Utilize readily available data 

Usable • Use reasonable, predictable assumptions 

• Provide clear, understandable output 

• Produce accurate forecasts of future market behavior 

Accurate • Result in correct and repeatable impact measures 

• Contain predictive capability for prices, quantities, etc. 

DOE criteria 

ES44856aq033094 2 

Artlur D Little 
Credibility

The MIM does not effectively measure major forces impacting

manufacturers.

Claim • Consumer price and life cycle cost drive demand

• MIM assumes: Q=a(P+ff*F)B

Implicit discount rates necessary to

make model function are improbable:

• Microwave ovens - 250°;'0

• Cooktops and ovens - 37%

• Room air conditioners - 49%

• Direct heating equipment - 50%

• Water heaters - 106%

Empirical data demonstrate that other

factors have major involvement:

Non-price/energy

factors

Source: Washer Analysis

ES44858aq033094 3

EE-RM-90-201 COMMENT OOF12

Credibility 

The MIM does not effectively measure major forces impacting 

manufacturers. 

Claim • Consumer price and life cycle cost drive demand 

• MIM assumes: Q=a(P+ff*F)B 

Implicit discount rates necessary to 

make model function are improbable: 

• Microwave ovens - 250% 

• Cooktops and ovens - 37% 

• Room air conditioners - 49% 

• Direct heating equipment - 50% 

• Water heaters - 106% 

Empirical data demonstrate that other 

factors have major involvement: 

Non-price/energy 

factors 

~ 

Source: Washer Analysis 

ES44856aq033094 3 
Credibility

The MIM does not effectively account for all significant effects on

manufacturers.

Claim • Return on equity is the proper measure of manufacturer impact

• Long-run and short-run models capture all major effects

Short-run model misses key aspects

of transition to implementation:

• Annualized investments omit timing

considerations

• Investment requirements

• Capital availability

• Measures only second-order revenue

effect

• Does not measure effects prior to

regulation date

Artlur D LittJe

Cash flow is a more sophisticated

and revealing tool:

• Return on equity misses several key

effects on manufacturers

• Cash flow is more revealing of timing

and other issues

• Cash flow allows easier assessment

of model performance

ES44856aq033094 4

EE-RM-90-201 COMMENT OOF12

Credibility 

The MIM does not effectively account for all significant effects on 

manufacturers. 

Claim 

• Return on equity is the proper measure of manufacturer impact 

• Long-run and short-run models capture all major effects 

Short-run model misses key aspects 

of transition to implementation: 

• Annualized investments omit timing 

considerations 

• Investment requirements 

• Capital availability 

• Measures only second-order revenue 

effect 

• Does not measure effects prior to 

regulation date 

Artlur D Little 

Cash flow is a more soph isticated 

and revealing tool: 

• Return on equity misses several key 

effects on manufacturers 

• Cash flow is more revealing of timing 

and other issues 

• Cash flow allows easier assessment 

of model performance 

ES44856aq033094 4 
Credibility

MIM short-run ROE analysis only measures revenue and profit

declines but misses major investment requirements..

1993 Refrigerator Standards

Estimated Net Income

1993 Refrigerator Standards

Estimated Industry Cash Flows

100

80

80

70

60

60

c: 50 c 40

0

.2 'e 20 § 40

E ... th 30 0

20 -20

10 -40

0 -60

1992 1993 1994 1995 1996 1997 1998 0 .. (II

1990 1991 01 01 01

01 Cll 01

... .. ....

'Ot

Cll

... '"

III

Cll

Cll

....

co

'"

01

....

ES44856aq033094 5

EE-RM-90-201 COMMENT OOF12

80 

70 

60 

c: 50 

.2 

§ 40 

E 

(,4 30 

20 

10 

0 

1990 

Credibility 

MIM short-run ROE analysis only measures revenue and profit 

declines but misses major investment requirements. 

1991 

1993 Refrigerator Standards 

Estimated Net Income 

1992 1993 1994 1995 

c: 

0 

'e 

... 

1996 1997 1998 

100 

80 

60 

40 

20 

0 

·20 

·40 

·60 

0 ... Ol Ol 

Ol en ... ... 

1993 Refrigerator Standards 

Estimated Industry Cash Flows 

(II 

Ol 

en 

... 

ES44856aq033094 5 
Credibility

The application of economic theory in the MIM is seriously flawed.

Claim • The MIM is a straightforward application of economic

theory

The MIM is based on at least twenty-three economic or other assumptions, in

addition to data requirements, all of which must be true for the MIM to be

accurate:

• Characteristics of firms (4)

• Economic theory (6)

• Cost/financial characteristics (10)

• Measurement (3)

ArUurD Little

• Virtually none of these

assumptions are verifiable from

external facts

• Existing factual data tends to

disprove many assumptions

ES44856aq033094 6

EE-RM-90-201 COMMENT OOF12

Credibility 

The application of economic theory in the MIM is seriously flawed. 

Claim • The MIM is a straightforward application of economic 

theory 

The MIM is based on at least twenty-three economic or other assumptions, in 

addition to data requirements, all of which must be true for the MIM to be 

accurate: 

• Characteristics of firms (4) 

• Economic theory (6) 

• Cost/financial characteristics (10) 

• Measurement (3) 

ArUur D LiHle 

• Virtually none of these 

assumptions are verifiable from 

external facts 

• Existing factual data tends to 

disprove many assumptions 

ES44856aq033094 6 
Credibility

The application of economic theory in the MIM is seriously flawed.

(continued)

Claim • Price is a markup over long term variable cost to cover

necessary investments

Initial assessment of markups from

theoretical structure were excessively

high (source - LBL):

• Potential measurement errors in

prices and marginal costs could

invalidate approach

• LBL resorted to Cournot theory in

attempt to support approach

Markups must be adjusted using

questionable assumptions to achieve

reasonable values:

• Cournot oligopoly result is based

upon highly restrictive assumptions

• No empirical evidence exists to

support LBL assertion that this yields

a good approximation of actual

behavior

• Actual data on number of firms is not

congruent with Cournot theory

ES44856aq033094 7

EE-RM-90-201 COMMENT OOF12

Credibility 

The application of economic theory in the MIM is seriously flawed. 

(continued) 

Claim • Price is a markup over long term variable cost to cover 

necessary investments 

Initial assessment of markups from 

theoretical structure were excessively 

high (source - LBL): 

• Potential measurement errors in 

prices and marginal costs could 

invalidate approach 

• LBL resorted to Cournot theory in 

attempt to support approach 

Markups must be adjusted using 

questionable assumptions to achieve 

reasonable values: 

• Cournot oligopoly result is based 

upon highly restrictive assumptions 

• No empirical evidence exists to 

support LBL assertion that this yields 

a good approximation of actual 

behavior 

• Actual data on number of firms is not 

congruent with Cournot theory 

ES44856aq033094 7 
Credibility

The MIM is not verifiable or understandable to all major users.

Claim • MIM is a sophisticated model which is empirically verified

and documented

Model is not verified:

• MIM does not generate predictions

which can be empirically tested

• Monte Carlo simulation does not

address validation between MIM

output and real world

ArtlurI)Little

Calculations are not understandable:

• Model process is opaque

• Documentation is highly technical

• Calculations take complicated

approach to a simple problem

• Cash flow analysis yields much more

direct assessment

ES44856aq033094 8

EE-RM-90-201 COMMENT OOF12

Credibility 

The MIM is not verifiable or understandable to all major users. 

Claim • MIM is a sophisticated model which is empirically verified 

and documented 

Model is not verified: 

• MIM does not generate predictions 

which can be empirically tested 

• Monte Carlo simulation does not 

address validation between MIM 

output and real world 

ArtJur D Little 

Calculations are not understandable: 

• Model process is opaque 

• Documentation is highly technical 

• Calculations take complicated 

approach to a simple problem 

• Cash flow analysis yields much more 

direct assessment 

ES44856aq033094 8 
Usability

The MIM does not utilize readily available data.

Claim • DOE admits that key assumptions are not based on

available data

Long run fixed and variable cost division is not available:

• Long run variable costs are key economic assumption

• Long-run variable/fixed cost division is unknown to manufacturers (DOE NOPR

page 10480)

ES44856aq033094 9

EE-RM-90-201 COMMENT OOF12

Usability 

The MIM does not utilize readily available data. 

Claim • DOE admits that key assumptions are not based on 

available data 

Long run fixed and variable cost division is not available: 

• Long run variable costs are key economic assumption 

• Long-run variable/fixed cost division is unknown to manufacturers (DOE NOPR 

page 10480) 

ES44856aq033094 9 

D 
Usability

The MIM does not use reasonable, predictable assumptions.

Claim • Input values for the MIM are readily obtainable

The MIM requires many input variables or values, most of which are not

available in the form required by the MIM. Examples include:

• Implicit consumer discount rates

• Price elasticity

• Operating cost elasticity

• Base case markup

• Shape parameter

• Economic profit

• Accounting assumptions

Artlur D Little

• One-time capital cost

• Short-run price response to

demand

• Prototypical firm cost structure

• Equity capital cost

• Many variables require accuracy

to four significant figures

ES44858aq033094 10

EE-RM-90-201 COMMENT OOF12

Usability 

The MIM does not use reasonable, predictable assumptions. 

Claim • Input values for the MIM are readily obtainable 

The MIM requires many input variables or values, most of which are not 

available in the form required by the MIM. Examples include: 

• Implicit consumer discount rates 

• Price elasticity 

• Operating cost elasticity 

• Base case markup 

• Shape parameter 

• Economic profit 

• Accounting assumptions 

Artlur D LiHle 

• One-time capital cost 

• Short-run price response to 

demand 

• Prototypical firm cost structure 

• Equity capital cost 

• Many variables require accuracy 

to four significant figures 

ES44856aq033094 1 0 
Usability

The MIM does not provide clear, understandable output.

Claim • The MIM is a usable understandable tool open to public

assessment and review

MIM operations are unclear: MIM output is obscure and confusing:

• No effective documentation of

operations

• No guide for users on functioning of

model

Artlur D LittJe

• ROE is limited measure

• Other results difficult to find and

interpret

ES44856aq033094 11

EE-RM-90-201 COMMENT OOF12

Usability 

The MIM does not provide clear, understandable output. 

Claim • The MIM is a usable understandable tool open to public 

assessment and review 

MIM operations are unclear: 

• No effective documentation of 

operations 

• No guide for users on functioning of 

model 

Artlur D Little 

MIM output is obscure and confusing: 

• ROE is limited measure 

• Other results difficult to find and 

interpret 

ES44856aq033094 11 
Accuracy

The MIM does not generate correct and repeatable impact measures.

Claim • The MIM provides an appropriate, consistent base for

assessing effects on manufacturers

MIM results are highly sensitive to

changes in long-run fixed/variable

cost assumptions:

• Changes in assumption change

magnitude of impact

• Changes in assumptions reorder

options

ArtlurD Little

Several key variables require

estimates to several significant

digits:

• Short-run price response

• Shape parameter

ES44856aq033094 12

EE-RM-90-201 COMMENT OOF12

Accuracy 

The MIM does not generate correct and repeatable impact measures. 

Claim • The MIM provides an appropriate, consistent base for 

assessing effects on manufacturers 

MIM results are highly sensitive to 

changes in long-run fixed/variable 

cost assumptions: 

• Changes in assumption change 

magnitude of impact 

• Changes in assumptions reorder 

options 

Artlur D Little 

Several key variables require 

estimates to several significant 

digits: 

• Short-run price response 

• Shape parameter 

ES44856aq033094 12 
Forecasting Capability

The MIM does not have valid, sophisticated forecasting capability.

Claim • The MIM has a theoretical foundation as a predictive

model

MIM starts with standard economic

theory, but predictions diverge from

actual situation:

• Predicted returns on equity/markups

much higher than observed

Artlur D Little

Cournot theory invoked to correct

situation:

• Restrictive theory

• Actual number of firms in most

segments violate theory

ES44856aq033094 13

EE-RM-90-201 COMMENT OOF12

Forecasting Capability 

The MIM does not have valid, sophisticated forecasting capability. 

Claim • The MIM has a theoretical foundation as a predictive 

model 

MIM starts with standard economic 

theory, but predictions diverge from 

actual situation: 

• Predicted returns on equity/markups 

much higher than observed 

Artlur D Little 

Cournot theory invoked to correct 

situation: 

• Restrictive theory 

• Actual number of firms in most 

segments violate theory 

ES44856aq033094 13 
Forecasting Capability

The MIM does not have valid, sophisticated forecasting capability.

(continued)

Claim • The MIM can provide adequate forecasts of key output

variables from readily forecastable input variables

MIM requires "correcting" variables which are neither forecastable nor, often,

known:

• Number of firms - arbitrarily adjusted

• Shape parameter - four adjusted significant figures

• Implicit discount rates improbable

• Industry elasticity - unproven, unverified estimate

ES44856aq033094 14

ArtJur D LittJe

EE-RM-90-201 COMMENT OOF12

Forecasting Capability 

The MIM does not have valid, sophisticated forecasting capability. 

(conti n ued) 

Claim • The MIM can provide adequate forecasts of key output 

variables from readily forecastable input variables 

MIM requires "correcting" variables which are neither forecastable nor, often, 

known: 

• Number of firms - arbitrarily adjusted 

• Shape parameter - four adjusted significant figures 

• Implicit discount rates improbable 

• Industry elasticity - unproven, unverified estimate 

ES44856aq033094 14 

ArtJur" LittJe 
Forecasting Capability

The MIM does not have valid, sophisticated forecasting capability.

(continued)

Claim • The MIM can be used to forecast prices, quantities, and

markups for products under regulatory scenarios

MIM cannot be validated versus

observed market conditions:

• Normalized output

• Non-verifiable input data

ArtlurD Little

Key factors driving forecasts/analysis

are inconsistent with actual

situations:

• Return on equity

• Markups

• Number of firms

• Implicit discount rates

ES44856aq033094 15

EE-RM-90-201 COMMENT OOF12

Forecasting Capability 

The MIM does not have valid, sophisticated forecasting capability_ 

(continued) 

Claim • The MIM can be used to forecast prices, quantities, and 

markups for products under regulatory scenarios 

MIM cannot be validated versus 

observed market conditions: 

• Normalized output 

• Non-verifiable input data 

Artlur D Little 

Key factors driving forecasts/analysis 

are inconsistent with actual 

situations: 

• Return on equity 

• Markups 

• Number of firms 

• Implicit discount rates 

ES44856aq033094 15 
Forecasting Capability

The MIM is not a useful predictive tool for prices, quantities, and

markups.

Claim • The MIM is all there is and is better than nothing

Computer output from a bad model is no more accurate or usable than no

output. The MIM confuses model complexity computer generation and

manipulation of large quantities of data with realism.

• Questionable theory

• Continuing adjustments to theory/variables in order to approximate known data

• No empirical validation

• Input data less easily estimated than estimating desired results directly

• Key data not consistent with known situation

ES44856aq033094 16

ArtlurI)Little

EE-RM-90-201 COMMENT OOF12

Forecasting Capability 

The MIM is not a useful predictive tool for prices, quantities, and 

markups. 

Claim • The MIM is all there is and is better than nothing 

Computer output from a bad model is no more accurate or usable than no 

output. The MIM confuses model complexity computer generation and 

manipulation of large quantities of data with realism. 

• Questionable theory 

• Continuing adjustments to theory/variables in order to approximate known data 

• No empirical validation 

• Input data less easily estimated than estimating desired results directly 

• Key data not consistent with known situation 

ES44856aq033094 16 

Artlur I) Little 
Conclusion

DOE should completely abandon the MIM. It serves no useful

purpose in assessing impact on manufacturers and defeats DOE's

obligation to make such an assessment.

• MIM does not meet minimum requirements for any model

• MIM does not meet DOE's requirement of forecasting capability

• MIM is excessively cumbersome and presents a confusing approach to a

relatively simple problem

ES44856aq033094 17

ArtlurI)Little

EE-RM-90-201 COMMENT OOF12

Conclusion 

DOE should completely abandon the MIM. It serves no useful 

purpose in assessing impact on manufacturers and defeats DOE's 

obligation to make such an assessment. 

• MIM does not meet minimum requirements for any model 

• MIM does not meet DOE's requirement of forecasting capability 

• MIM is excessively cumbersome and presents a confusing approach to a 

relatively simple problem 

ES44856aq033094 17 

Artlur" Little