Biofuel economics and the fallacy of composition

A few years back, when corn was trading for less that $2/bushel, ethanol started to make sense to a lot of people, and it wasn't just politics. I remember meeting young policy wonks in bars in Washington, DC and they would enthusiastically tell me how things had changed, that corn was cheap, that they could get more ethanol from each bushel of corn, that it was a good substitute for MTBE to boost octane and make the fuel burn cleaner, and oil prices were expected to rise. It really did make sense, they told me, and there was support on all sides. All of this was true. They were sincere.

What a long strange trip its been since then.

I was skeptical from the beginning for the following reason: the stylized facts told me the demand for corn was very steep. I was pretty sure corn supply was steep, too. That meant the price of corn would go up a lot if ethanol production increased to any significant fraction of the fuel market. The problem was that these non-economist policy types were taking the price of corn as fixed. They didn't consider how much the price would rise once ethanol was scaled up by a significant amount.

This is what some refer to as the fallacy of composition. Each farmer and each ethanol plant takes prices as given. Individually each is too small to influence price. Collectively, however, they can have a huge influence on price. What is true for a small part of the market is not true for the whole market.

This is basic economics. It's just supply and demand. Part of the problem was we didn't really have good clear estimates of supply and demand elasticities, which made this difficult to explain in a concrete way. That is what motivated my study with Wolfram Schlenker. I guess we were a little late to the table.

Now focus is turning toward other kinds of biofuels, like cellulosic fuels derived from jatropha, switchgrass, miscanthus, sorghum, algae, and waste wood products. The key economic question is how these biofuels will scale up. It's not enough to show that they may make sense at current prices, because if these fuel sources are used on a large scale, prices will go up. The key economic question concerns what activities these alternative biofuels would displace if done on a massive scale. What do the supply and demand curves look like for competing uses of biofuel resources?

These alternative biofuels may hold promise. But I still worry that people are not asking this key economic question. So, if you're doing work on biofuels, please keep in mind that prices for raw biofuel materials will change and that the key economic question concerns how much prices will change. If you don't account for these price changes, you're committing the fallacy of composition, just like those policy wonks singing the virtues of ethanol back when corn was less than $2/bushel.