Textbook Biofuel Subsidy Analysis - the Effect of Biofuel Subsidies on the Price of Beer

In an earlier post on biofuel subsidies, I explained the chain of events leading from biofuel subsidies to increased beer prices.  Many of the things occuring in the market for ethanol and related markets are almost textbook examples of economics in action.

Consider a market for ethanol summarized graphically in Figure 1.  If the market is competitive and the product is unsubsidized, then price and quantity will be determined at the intersection of the demand and supply curve.  Pe is the equilibrium price and Qe is the equilibrium quantity traded in the marketplace.

Introducing a subsidy, as shown in Figure 1, regardless of who directly receives it, causes a wedge to be driven between the price ethanol producers sell at (denoted by Ps) and the price that ethanol buyers pay (Pb).  If the subsidy is given to producers, they offer more for sale, but to give buyers an incentive to consume more, the price they pay must fall below the equilibrium price.  If the subsidy is given to buyers, they have an incentive to buy more.  But to get sellers to offer more for sale, they must get a higher price.  Whatever the case, the price sellers receive goes up and the price the buyers pay falls using the unsubsidized equilibrium price as our benchmark.  The difference between Ps and Pb is the amount of the subsidy per unit sold.

Since the quantity of biofuels supplied  increases, so does the demand for its ingredients, like corn.  This increases the demand for things such as corn, pushing up its price as shown in Figure 2.  D is the original demand curve and D' is the new curve.

Farms are little more than firms in the crop production market and, as firms, they employ resources in the production of crops.  Since corn and other crops are complements in production, rational farmers take some land out of the production of crops like cotton and barley production and use it to plant more corn.  But at the same time, the supply of barley decreases from S to S', raising it's price as shown in Figure 3. 

Since barley is an important ingredient in the making of beer, the supply of beer necessarily falls as well from S to S', and it's price rises as shown in Figures 4a and 4b.  How much it rises depends on the sensitivity of beer drinkers to price changes.

If the demand for beer is not as elastic at each point as in Figure 4a, the
price of beer will rise further and the quantity will not fall as much.

The light gray demand curve - labelled as Do ("o" for original) - and price and quantity notations are the same as those in Figure 4a above and I have them in 4b for comparisons.  If demand is more inelastic, consumers won't cut back as much, but they will pay higher prices than if they were more price sensitive.

So the next time you see ethanol-mixed gas prices at the pump that are lower than straight gas, just remember while the ethanol subsidies are helping to drive down the prices of ethanol blended gasses, there are other goods that you buy that are more costly because of the ethanol subsidies.  It is not clear to me that "we" are better off by becoming energy independent by giving trememdous ethanol subsidies.

Comments

[J.Z. Smith]

This is a good example of the related markets or general equilibrium approach to tax/subsidies, but the crop most highly affected by higher corn prices is soybeans, not barley. Barley production is highly concentrated in NoDak, Idaho and Montana (about 70% of US production).

Another interesting piece of the analysis that is overlooked is the subsidy on ethanol-blend gas is a (growing) cost to the government, but the increased demand for corn stimulated by the subsidy and higher fuel prices has caused corn prices to increase, which has significantly reduced the federal government outlay of subsidies linked to corn prices, namely the LDP/loan rate and the countercyclical payment. Only component of subsidy to corn growers for this year is the Direct Payment ($0.28/bushel). I would be willing to bet that the savings in these subsidy outlays could easily offset the growth in ethanol subsidies.