Business Perspectives

Economic lessons abound in ethanol mandate debate

Politics may make strange bedfellows, but economics can split up long-established relationships. That is evident in the split within the farm bloc as several livestock-producer organizations joined in petitioning the government for a waiver from the EPA mandate that all U.S. gasoline contain 10 percent ethanol or some other oxygenate.

The reasons are obvious. The ongoing drought has pushed up corn prices to nearly twice the usual levels. The resulting high feed costs are punishing livestock producers. Yet about a third of U.S. corn goes to ethanol plants. Demand for ethanol is not driven by market forces but rather by the government mandate. Remove that, even temporarily, and less corn would go into ethanol, easing corn prices at least somewhat and thus relieving some stress on livestock producers.

For econ teachers, U.S. ethanol policies are the gift that just keeps on giving, because they illustrate so many economic principles. Consider just a few that bear on the question of whether the administration should grant a waiver to the ethanol mandate as requested by the livestock producers.

First, the fact that the mandate even exists is an example of “rent seeking.” This occurs when a group, such as corn growers, uses political power to get public policies that give them higher incomes than they would get in a free market.

Second, the fact that a few hundred thousand corn growers can get a mandate that favors them, to at least the slight disadvantage of 300 million other Americans, is an example of what Mancur Olson called “the logic of collective action.”

A small number of people, such as corn growers, each of whom has much to gain or lose, are more likely to organize politically than a much larger group, such as consumers, of which no single member has much at stake.

Third, corn ethanol is an example of an “increasing cost industry.” This is often confused with “economies or diseconomies of scale,” or how average production costs change with a smaller or larger factory. The question of an “increasing or decreasing cost industry” deals, rather, with how production costs change as a whole industry gets larger or smaller.

Personal computers are an example of a decreasing cost industry. Costs have fallen as global output has increased, although technological change also plays a part.

But ethanol is a classic case in which average costs for the whole industry rise as the whole sector gets larger. That is because corn needs good farmland, and this is limited in quantity. There is no similar limiting factor for motherboards or hard drives.

As more ethanol plants have come on line, they, in effect, are bidding against each other for a limited supply of their primary input, corn. Prices rise, and as they do, ethanol becomes less profitable for any given selling price. This is a long-term dilemma for the industry, regardless of short-term weather factors.

But this is all exacerbated by the fact that the overall supply of and demand for corn is highly inelastic, especially in the short run. The quantities supplied or demanded don’t change much in response to price changes.

The flip side of that is when external factors, such as drought, change output; then prices can change dramatically.

Finally, both ethanol plants and most livestock production are capital intensive. That is, a lot of money is tied up in physical facilities and amortizing these facilities is a fixed cost that must be paid, regardless of the level of output, as long as the producer does not go out of business. So producers will keep on producing as long as the revenue from producing one more unit of ethanol or chicken or beef or milk exceeds the extra variable cost, i.e. corn, of that last unit. But while a producer in this situation is covering some of its fixed costs, it isn’t covering all of them and it will go broke eventually unless the situation improves.

So both sides have a lot at stake. If the Obama administration does not grant a waiver of the ethanol mandate, virtually all livestock producers will continue under extreme financial stress over coming months. If it grants the waiver, ethanol plants, already in an unfavorable input-cost vs. product-price squeeze will be in an even worse situation.

Consumers would benefit from a waiver, but I doubt the administration will give that much thought. The question is what will happen to the farm vote.

Farmers fall along a spectrum. At one end are ranchers and stand-alone livestock raisers, especially in poultry and hogs, who don’t raise any corn at all. At the other end are corn producers who have no livestock. And in between are tens of thousands of farmers who both grow corn and raise livestock. Some are net buyers of corn most years, some are net sellers. Just how the votes will fall out in a situation like this is anyone’s guess.