Ethanol and Corn Prices: The Role of US Tax Credits, Mandates, and Imports

Abstract

The recent global increases in agricultural commodity prices can be attributed to a number of factors, but one of the most important was the large increase in US ethanol production. We argue that without a complex web of ethanol policies, little ethanol would be produced in the United States. This is likely the case for biofuel production in the EU, Canada, and other developed countries as well. It is increasingly evident that developing countries have a comparative advantage in the production of biofuels and their feedstock. Yet policies have been enacted that discriminate against trade. The result is little international trade in biofuels. This chapter puts into perspective the effects of US ethanol policies on commodity prices, as well as their impact on US terms of trade.

Appendix: Price Relationships Between Corn, Ethanol, and Gasoline

A bushel of corn can be converted into ethanol at a constant cost of c ₀, resulting in β gallons of ethanol and δ bushels of by-product, which can be sold back in to the corn market. Estimated values of β and δ are 2.8 and 0.31, respectively (Eidman, 2007).

A bushel of corn can be purchased for the market price of corn, P _C , and converted to ethanol and corn, resulting in revenue of $\beta P_{\textrm{E}} + \delta P_{\textrm{C}}$, where P _E is the market price of ethanol per gallon. This results in a total marginal profit of $\pi ' = \beta P_{\textrm{E}} + \left( {\delta - 1} \right)P_{\textrm{C}} - c_0$. Given that markets function well, if marginal profits from converting corn to ethanol are positive, $\pi ' > 0$, then producers will continue to demand corn for ethanol until the price of ethanol is bid down and the price of corn bid up, resulting in zero marginal profit. Thus, in equilibrium, the price of ethanol and corn must follow the relationship

$$P_{\textrm{C}} = {{\left( {\beta P_{\textrm{E}} - c_0 } \right)} \mathord{\left/{\vphantom {{\left( {\beta P_{\textrm{E}} - c_0 } \right)} {\left( {1 - \delta } \right)}}} \right.\kern-\nulldelimiterspace} {\left( {1 - \delta } \right)}}$$

((9.5))

so long as ethanol is produced in equilibrium. Otherwise, $P_{\textrm{C}} > ( \beta P_{\textrm{E}} - c_0 )/\break ( 1 - \delta )$, implying negative marginal profits from converting corn to ethanol.

Ethanol can be mixed with gasoline to produce fuel. We treat ethanol as a perfect substitute for gasoline. While fuel containing high concentrations of ethanol (such as E85) can currently only be used by a small percentage of the cars on the road in the United States, nearly all automobiles can use fuel containing lower levels of ethanol (such as E10). Hence, our treatment of ethanol as a perfect substitute for gasoline is an abstraction. However, less than 1% of ethanol is sold in concentrations higher than that found in E10. Thus, for the concentrations of fuel found in the market, ethanol can be reasonably expected to perform as a perfect substitute.

The energy content of ethanol is substantially lower than that of gasoline (by about 30%). We suppose that individuals value ethanol and gasoline for their contributions to vehicle miles traveled. Hence, in equilibrium,

$$P_{\textrm{E}} = \lambda P_{\textrm{G}}$$

((9.6))

where P _G is the market price of gasoline per gallon, and λ is the ratio of miles per gallon derived from ethanol to miles per gallon derived from gasoline (estimated to be 0.70). Again, if this equality did not hold, consumers would be led to adjust their consumption of ethanol and gasoline until equilibrium was achieved. This together with (9.1) implies that

$$P_{\textrm{C}} = {{\left( {\beta \lambda P_{\textrm{G}} - c_0 } \right)} \mathord{\left/{\vphantom {{\left( {\beta \lambda P_{\textrm{G}} - c_0 } \right)} {\left( {1 - \delta } \right)}}} \right.\kern-\nulldelimiterspace} {\left( {1 - \delta } \right)}}$$

((9.7))

if ethanol is produced.

The introduction of taxes and tax credits fundamentally alter the equilibrium price relationships given in equations (9.6) and (9.7) by altering the profit incentives and the marginal cost of vehicle miles. Let t represent the volumetric tax on all fuel and t _c the tax credit awarded to blenders for use of ethanol. Then, we can rewrite equations (9.6) and (9.7), respectively, as

$$P_{\textrm{E}} + t - t_c = \lambda \left( {P_{\textrm{G}} + t} \right)$$

((9.8))

and

$$P_{\textrm{C}} = {{\left( {\beta \left[ {\lambda P_{\textrm{G}} + \left( {\lambda - 1} \right)t + t_c } \right] - c_0 } \right)} \mathord{\left/{\vphantom {{\left( {\beta \left[ {\lambda P_{\textrm{G}} + \left( {\lambda - 1} \right)t + t_c } \right] - c_0 } \right)} {\left( {1 - \delta } \right) \equiv P_{{\textrm{Eb}}} }}} \right.\kern-\nulldelimiterspace} {\left( {1 - \delta } \right) \equiv P_{{\textrm{Eb}}} }}$$

((9.9))

where P _Eb can be thought of as the bushel-equivalent price of ethanol. Further, it is convenient to define $P_{{\textrm{Gb}}} \equiv {{\left( {\beta \left[ {\lambda P_{\textrm{G}} + \left( {\lambda - 1} \right)t} \right] - c_0 } \right)} \mathord{\left/{\vphantom {{\left( {\beta \left[ {\lambda P_{\textrm{G}} + \left( {\lambda - 1} \right)t} \right] - c_0 } \right)} {\left( {1 - \delta } \right)}}} \right.\kern-\nulldelimiterspace} {\left( {1 - \delta } \right)}}$ as the bushel-equivalent price of gasoline. The implication of equation (9.9) is that for every one cent per gallon change in the price of ethanol, the corn price changes by 4.06 in $ per bushel. This means the corn price is very sensitive to a change in the tax credit or oil price.