Wednesday, November 19, 2008

The Economics of Ethanol

A friend of mine asked me to write a guest post for his blog. Here is it reproduced here.

Ethanol is an immensely complicated issue that requires a detailed institutional background to fully appreciate, and those with a little bit of knowledge often jump to wildly wrong conclusions.

On the Benefits of Ethanol

The environmental benefit of ethanol has been hotly disputed over the years. Various studies have found various things over the years as is typical in science (a recent study finds that 1/3 of the most cited publications in a top medical journal are refuted in just a few years). A meta-analysis of all of these papers shows a clear time trend. Newer studies show greater benefits. The reason for this is simple. While the environmental benefits from corn-based ethanol are arguably small today, they will only grow in the future. Corn yields have been increasing steadily for decades, and there is every reason to expect that to continue. Thus we should get more ethanol per environmental cost each year. Furthermore, new enzymes are being developed again to get more ethanol from the same amount of corn, thereby further increasing the amount of ethanol per given input.

All of this also does not account for the possibility of more dramatic technological shifts that subsides make possible. Current car engines are tuned for gasoline from oil. However, engine tuned for gasoline from ethanol could lead to 25-30% increases in engine efficiency. Furthermore, the infrastructure being developed is helping to pave the way for new biofuels, like biodiesel and cellulosic ethanol that have substantial and already demonstrated environmental benefits.

Finally, environmental analyses ignore the other benefit of ethanol, which is a diversification away from oil consumption. Much of the problem s in the oil markets comes from the monopoly power of the oil industry given the lack of substitutes for oil. By helping develop a viable substitute, there are immense gains beyond just the environment, for example, dampening the geopolitical power of OPEC, and alleviating the resource curse in the Middle East.

On the Ethanol Subsidy.

Many people wrongly assume that the government specifically subsidizes only corn based ethanol. In fact, regular ethanol gets a 51 cent per gallon subsidy, biodiesel gets around 80 cents, cellulosic ethanol gets over $1. Other fuels get subsidized in their own way. And in fact a system of mandates and other tax credits makes total subsides substantially higher and substantially more complicated.

This is not an ideal system. A carbon tax would be much simpler that would replace this myriad of complicated and overlapping policies. But we do not live in an ideal world. So on the simple question of whether we should repeal the ethanol subsidy, we go back to the tools of cost benefit analysis (something I used to teach back at Stanford).

What are the costs of a subsidy? The subsidy is effectively just a transfer from one American to another, so the cost is only the cost associated form the distortions to the economy from raising that 51 cents. A large literature estimates the cost of raising 51 cents to be around one quarter of that, or around 12.5 cents. Is that worth it?

It is first worth noting that mathematically, a subsidy on a good works exactly the same way as a tax on a bad. So if you believe we should increase gasoline taxes by 51 cents, then you should support a 51 subsidy for ethanol.

The benefits of an extra gallon of ethanol are hard to quantify, but if you add it up (the small environmental benefit, the impact of geopolitics, the fostering of technological innovation, the support of an agricultural lifestyle) it is actually fairly easy to find benefits far outweighing 12.5 cents.

Again, subsides for ethanol is messy ugly kludgy policy. But absent a comprehensive gasoline/carbon tax, repealing the subsidy could be even worse.

On the Ethanol Tariff

Many people (including free-market economists) decry the 54 cent tariff on imported ethanol, without really understanding the institutional background for the tariff. First of all, most imported ethanol falls under various free trade agreements that makes them exempt from the tariff. Second of all, while it is true that we place a tariff on Brazilian ethanol, Brazilian ethanol also enjoys the 51 cent subsidy, hence leaving Brazilian ethanol producers no better or worse off than in a free market environment. The main purpose of the tariff is just to make sure only American ethanol producers get the subsidy.

Whether this is fair from a global justice perspective is debatable but from a standard economic cost-benefit analysis, it is eminently reasonable. Recall that a transfer between two Americans is not considered an economic cost from the point of view of America since it has no net effect on American social welfare (only the dead weight loss of raising the taxes is considered a cost). However, a transfer from American tax payers to a Brazilian producer is considered a cost.

On Ethanol and Food Prices:

It is incredibly difficult to estimate the impact of biofuels on food prices. This is why most respectable economists decline to give exact numbers. I was asked to do such an analysis for the White House in 2007, and found that drought and crop failure combined with rising energy costs (a major input in production) and increased meat consumption in places like China, account for a far larger share of the price increase. This may have changed in 2008 (though I doubt it), though either way, the argument seems strange to me.

I find it incredibly odd that the same economists (like those at even Oxfam) who have for years been decrying farm subsides for depressing food prices and therefore hurting developing world farmers are today decrying biofuel subsides for increasing food prices. It is hard to say whether the developing world would prefer lower or higher food prices, though one would think that since developing countries tend to have a comparative advantage (note I said comparative, not absolute advantage) in agriculture (seen by the fact that they devote most of their labor force to agriculture), then increasing food prices leads to a favorable shift in their terms of trade, which means it should be good for developing countries overall (yes it hurts the non-farmers in these countries, but it helps all of the farmers who tend to out-number the non-farmers, leading to a net gain).
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