Ethanol, Corn Prices, Biofuels Policy, Tax Credits, RFS, Food versus Fuel, Food Security and Poverty, Resource /Energy Economics and Policy, Q28, Q11,

Elam, Thomas E.

English

Research Papers in Economics

12  CHOICES  3rd Quarter 2008 • 23(3) 
The magazine of food, farm, and resource issues
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Food or Fuel?  
Choices and Conflicts
Thomas E. Elam
JEL Classification : Q28, Q11
The quiet world of farming and food production is un-
dergoing  a  “sea  change”  of  unprecedented  proportions. 
Since 2005 we have seen a rise in energy prices coupled 
with policy decisions that have expanded biofuels markets 
for crops that were traditionally used almost exclusively to 
feed people and farm animals. In addition, a weak U.S. 
dollar and increasing global food demand have added to 
the upward price pressure and increased volatility in major 
crop markets. 
Governments of the United States and the Economic 
Union (EU) have reinforced changing market conditions 
with policy choices that tilt the balance towards channel-
ing crop production into biofuel production. The man-
dates and subsidies in these policies are not transparently 
linked to market forces. Debate over the wisdom of mar-
ket–insensitive biofuels policy that adds to crop demand 
and price uncertainty in a time of record–high prices has 
become heated.
The basics of what is happening to market supply and 
demand forces are not difficult to understand. The wrinkles 
added by biofuels policy are, on the other hand, both sig-
nificant and add complexity.
Energy Markets Alone Are Causing Major Changes in 
Agricultural Markets
For economists, the increase in oil prices and the resulting 
link to the energy value of crops has turned out to be a test 
of just how well our theories can predict the outcome. I am 
happy to report that the theories have passed the exam with 
flying colors. This is cold comfort for those paying histori-
cally high prices for gasoline, corn, soybean oil and soybean 
meal, but at least we know “how” and “why”.
Market–based demand for crops used in food produc-
tion  is  somewhat  different  from  market–based  demand 
for biofuel in one important sense. In the food market, as 
production increases price is expected to decline along a 
short–run demand curve. Price–inelastic demand for food 
generally leads to large changes in price for relatively small 
changes in production. Food demand for crops is also not 
strongly linked to other commodity sectors. This is not 
true for demand for food crops used as biofuels. 
The global market for petroleum–based energy alone, 
in terms of energy production, is substantially larger that 
all the potential fuel energy that can be produced from 
the world’s food crops. Unless we are willing to sharply re-
duce food consumption we can use only a fraction, and 
a small one at that, of the current world’s food supply to 
produce fuel. In the world of energy, potential food–based 
biofuel production simply cannot come close to replacing 
a meaningful amount of petroleum, much less total fossil 
fuel consumption. (Including natural gas and coal)The 15 
billion gallon U.S. ethanol RFS for 2012 would use about 
6.2% of the 2008 global grain crop to replace about 6.8% 
of the 2008 U.S. gasoline supply and only 0.8% of global 
oil production. This creates an asymmetric situation where 
the biofuel supply is too small relative to the global energy 
market to have much effect on energy prices, but energy 
prices can have a major effect on food prices. 
To  put  it  simply,  the  limiting  factor  on  expanding 
food–based  biofuel  production  is  the  world’s  desire  for 
food, not fuel demand. Even more simply, we like to eat. 
Open up the possibility of producing biofuels from other 
sources that do not compete for farmland (algae, wood 
waste, manure, solid waste, and others) and the limits on 
production can be expanded. That technology is still, after 
many years of work, “not quite” ready. It may be a factor in 
the long term biofuels market, but not today’s.
If biofuels are priced competitively, they are a near–per-
fect substitute for petroleum fuels. A gallon of ethanol has 
about 66% of the BTU content of a gallon of gasoline.   3rd Quarter 2008 • 23(3)  CHOICES  13
Gallon–for–gallon methyl ester (the 
chemical name for the purified prod-
uct extracted from fats and blended 
with diesel fuel to make bio–diesel) 
has very close to 100% of the BTU 
content of diesel. 
For  current  engine  technology 
that means that, at 66% of the price 
of gasoline, ethanol is a near–perfect 
substitute for gasoline. If E85 (85% 
ethanol,  15%  gasoline)  is  priced  at 
71% of the price of gasoline, motor-
ists  will  not  care  whether  they  buy 
regular gasoline or E85 as their fuel 
cost per mile will be about the same. 
Modified engines can take advantage 
of ethanol’s higher octane rating and 
reduce  the  energy  penalty  through 
higher efficiency than is possible with 
today’s  gasoline–based  technology. 
There are none of these engines on 
the market today. Diesel buyers can 
pay the same price for methyl ester as 
diesel and get the same fuel cost per 
mile.
Until oil prices passed about $70 
per barrel the market economics of 
converting crops to fuel were not very 
favorable. Grains and fats were priced 
too  high  compared  to  their  energy 
value to make it profitable to convert 
them into motor fuels. We did pro-
duce some ethanol and methyl ester, 
but  only  with  the  help  of  govern-
ment subsidies. With oil at over $100 
a barrel in 2008 the value of crops 
converted into fuels has been signifi-
cantly higher than food–market val-
ues of just a few years ago. Subsidies 
are no longer required for biofuels to 
be a viable use of crops. That is a huge 
change in market fundamentals.
So,  what  happens  if  crop–based 
production of biofuels is limited to 
only  a  small  fraction  of  the  petro-
leum  market  and  petroleum  prices 
suddenly increase, setting values for 
crops  that  are  higher  than  prevail-
ing  food–market  prices?  According 
to  economics  textbooks  the  classic 
market–based process should unfold 
something like this:
1.  Biofuel  prices  will  increase  with 
energy prices, but crop prices will 
not immediately follow.
2.  Biofuel  producer  profits  will  in-
crease from higher biofuel prices.
3.  Biofuel  producers  will  expand 
production, but with a time lag.
4.  Biofuel  production  increases  are 
too small to have a material affect 
on overall fuel prices.
5.  However,  as  biofuel  production 
grows  so  does  demand  for  the 
crops used.
6.  Production  of  the  biofuel  crops 
is  limited  by  available  land  and 
yields, less of those crops are avail-
able for food use.
7.  The biofuel crops will take acres 
from other crops, and their prices 
will also increase.
8.  With time lags, higher crop prices 
will  be  reflected  in  higher  food 
prices  and  lower  food  produc-
tion.
9.  Higher demand for limited crop 
supplies will cause crop prices to 
increase until biofuel profits dis-
appear  and  fuel  value  of  crops 
equals food value.
10. Biofuel expansion will stop, and 
some  marginal  producers  may 
exit. 
11. If  crop  production  increases 
enough to cause a crop price de-
clines, loop back to Step 3.
Although it seldom happens in real 
life, the economics textbooks in this 
case  predict  what  has  happened  up 
through  Step  9.  A  marked  slowing 
of  new  ethanol  plant  construction 
indicates that Step 10 is also in the 
process  of  occurring.  Longer  term 
implications of higher energy prices 
for agricultural markets include, but 
are not limited to:
1.  Energy markets and food markets 
become tightly coupled. That is, 
increases  (decreases)  in  energy 
prices will cause crop prices and 
food production costs to increase 
(decrease).
2.  Prices  for  crops  and  feedstuffs 
other than those used for biofuels 
will also be affected due to compe-
tition for land and substitution in 
use.
3.  Land prices and rents will move 
in tandem with changing energy 
prices; landowners are potentially 
the major beneficiaries in the form 
of higher land prices.
4.  High  (relative  to  pre–2007)  en-
ergy  prices  will  cause  increased 
demand for farm inputs and will 
cause crop production costs to in-
crease.
5.  Food production volume will be 
affected by the demand and price 
for energy via the biofuels mar-
ket.
Bruce  Babcock  of  Iowa  State  Uni-
versity and Wallace Tyner of Purdue 
University  have  come  to  essentially 
these  same  conclusions  (Babcock) 
(Tyner).
Energy Policy Reinforcing the 
Energy Market Linkage to Agri-
culture and Food
Energy  policy  affects  food  and 
agriculture  through  biofuels  and 
their links to both energy production 
and crop demand and use. The bio-
fuel policy tools commonly used are 
subsidies for biofuel producers, man-
dated production and/or use, and tar-
iffs designed to protect the domestic 
market.  Current  U.S.  policy  makes 
use of all three of the tools. EU policy 
is focused in mandates.
Mandated use of ethanol in the 
United  States  was  first  proposed  in 
2003,  but  not  enacted  until  2005. 
The Energy Policy Act of 2005 had an 
ethanol mandate (the Renewable Fuel 
Standard, or RFS) that was relatively 
modest and did not have a significant 
effect on agricultural markets. How-
ever, enacted on December 19, 2007, 
the Energy Independence and Secu-
rity Act of 2007 (EISA) set forth a 
much higher RFS.1  CHOICES  3rd Quarter 2008 • 23(3) 
To put the higher EISA RFS in 
perspective, the crop year 2008/2009 
EISA  RFS  is  about  10  billion  gal-
lons of ethanol. It would require at 
least 91 million tons of corn be used 
from the 2008 U.S. crop. USDA is 
currently  (as  of  August  12,  2008) 
forecasting  104  million  metric  tons 
of corn use, about 4% of total global 
grain production, for ethanol produc-
tion from the 2008 corn crop. While 
the 2008/2009 ethanol mandate may 
be slightly smaller than forecast pro-
duction,  the  presence  of  a  market 
guarantee of this magnitude could be 
underpinning current corn prices.
In addition to the RFS mandate, 
U.S.  policy  also  grants  the  biofuels 
industry tax credits, paid to the com-
pany that blends ethanol or biodiesel 
with petroleum fuels. The tax credits 
do  not  adjust  with  market  condi-
tions. Fixed cash infusions into bio-
fuel use raise the value of biofuels to 
the blending company and raise the 
market price of biofuels without re-
gard to energy or crop prices. With 
higher  biofuels  prices  the  biofuel 
producer has an advantage over other 
crop buyers. However, there can be 
only one market price for any crop, so 
the biofuels industry eventually bids 
much of the value they receive from 
the tax credits into crop prices. The 
tax credits are adding to the upward 
pressure on crop prices on top of the 
market pressures from higher energy 
prices.
The end result with both the tax 
credits and mandates is that much of 
their value will always eventually be 
bid into biofuel prices, and then crop 
prices. Crop farmers, not the ethanol 
industry,  become  the  major  benefi-
ciaries of the tax credits. Eventually, 
higher crop prices will be capitalized 
into  land  prices,  and  the  ultimate 
benefit will accrue to landowners.
Finally, the ethanol tariff of $0.54 
per  gallon  is  a  barrier  which  helps 
protects U.S. ethanol producers from 
more  efficient  producers  outside  of 
the United States. However, in a sense 
the tariff and tax ethanol credit can-
cel each other, and the net effect is to 
deny  foreign  ethanol  producers  the 
value of the U.S. tax credit paid for 
all ethanol in the prices they receive.
There has also been political fall-
out over biofuels policy. The voice of 
agriculture is fracturing along lines of 
crop producers versus crop users. As 
the public sees crop farmer income 
grow while their food prices increase 
(MSNBC) support for farm programs 
and biofuels policy may erode.
What Happens When Policy 
Meets Cold Reality?
History  teaches  us  that  in  most 
cases reality eventually wins. We also 
often see “unintended consequences.” 
Energy policy can set any mandated 
level of ethanol production, but even 
the  U.S.  Congress  or  the  President 
cannot change the weather or double 
crop yields overnight. Actually, to re-
place just 50% of U.S. gasoline con-
sumption with E85 would take 100 
billion gallons of ethanol.  Including 
9 billion for food, feed and exports, 
corn  production  would  need  to  be 
over 40 billion bushels to make that 
happen.    From  80  million  acres  of 
U.S. corn it would take a yield of over 
500 bushels per acre. We are currently 
at about 160 bushels in a good year.   
We also would still be importing sig-
nificant amounts of crude oil. When it 
appeared that the 2008 corn and soy-
bean crops were at risk from flooding, 
corn prices soared to unprecedented 
highs.  On  June  18,  2008,  several 
corn futures contracts closed at over 
$8 for the first time ever. Cash corn 
was selling for close to $9 per bushel 
in California. Prices of soybeans and 
wheat were also on the rise. Within 
a few weeks it became apparent that 
the crops were improving, and prices 
declined, but remained at historically 
high levels. 
Why did this happen when even 
a  damaged  2008  corn  crop  could 
still have been the 4th largest on re-
cord? A major factor was likely that 
for the first time in history we had 
$140+ crude oil prices coupled with 
an expanded biofuels industry with a 
RFS mandate large enough to use suf-
ficient grain relative to production to 
make a substantial difference in crop 
prices. 
While improved weather at least 
temporarily alleviated the 2008 sup-
ply crunch, it is not clear at this point 
just how such a scenario of tight crop 
supplies and EISA policy will inter-
act. Corn prices at the levels of June, 
2008 were not profitable for ethanol 
producers, food or animal feed users. 
We were, for a few weeks, in an un-
precedented bidding process to deter-
mine who was to have access to a corn 
crop that was predicted to be much 
smaller than that of 2007. At some 
point we would have reached prices 
that would have rationed use, or the 
RFS would have been reduced. Had 
the  RFS  been  reduced,  prices  may 
have dropped sharply overnight.
Finally,  along  with  higher  crop 
prices  we  have  also  seen  a  marked 
increase in price volatility. The coef-
ficient of variation of monthly 2007–
crop cash corn prices has been about 
three times the level of the 2000–2006 
crops. The increased demand for bio-
fuels, partly market driven and partly 
as a result of policies promoting their 
production, has reduced crop stocks 
levels, driving price volatility higher. 
Less stable crop prices raises another 
set of issues regarding how crop users 
will manage higher risks.
Why We May Need to Re–exam-
ine Current Energy Policy
Arguably, the biofuels features of the 
Energy  Independence  and  Security 
Act of 2007 (EISA) will achieve few of 
the goals implied by the law’s name. A 
recent Iowa State study of EISA poli-
cies concludes that they are in fact not 
designed to promote cleaner energy 
production,  energy  independence 
or energy security, but rather are in-
tended to increase farm incomes and 
land  prices  (Rubin,  Carriquiry,  and   3rd Quarter 2008 • 23(3)  CHOICES  1
Hayes). The study examined a wide 
range  of  policy  options,  and  con-
cluded that the policy set contained 
in  EISA  had  the  largest  benefit  for 
agriculture of the options examined. 
In their conclusions the authors state 
“There is strong evidence to suggest 
that  the  primary  purpose  of  these 
(EISA biofuel) polices was to remove 
land from food and feed production 
and in so doing to increase farmers’ 
and landowners’ incomes.”
By  establishing  price–insensitive 
subsidies  and  mandates  EISA  also 
partially isolates a large portion of key 
crops  from  market  forces,  pushing 
adjustments in production and prices 
onto the food production sector. The 
result  is  higher,  more  volatile,  food 
prices  and  reduced  security  of  our 
world’s food supply. Increased biofuel 
production, subject to the whims of 
weather,  also  arguably  reduces  even 
our overall fuel security. 
The  payoff  for  ESIA  biofuels 
policy is small relative to the energy 
market. Even if the 36 billion gallon 
EISA mandate for 2022 could be met 
it would not make a material change 
in the country’s dependence on for-
eign  oil.  The  petroleum  equivalent 
of the mandate is about 570 million 
barrels of oil per year, or only about 
15% of 2008 U.S. oil imports. That 
still leaves the U.S. highly vulnerable 
to world oil market interruptions.
On equity grounds biofuels policy 
has helped promote a transfer of in-
come and wealth from food consum-
ers and crop users to crop producers 
and  land  owners  (Taheripour  and 
Tyner). In effect, biofuels policy can 
be seen as a regressive food tax, the 
proceeds of which largely go to farm 
owners. 
Current U.S. biofuels policy de-
serves to be revisited by Congress and 
the  Administration.  Together  with 
oil price instability, EISA’s inflexible 
biofuel mandates, subsidies and tar-
iffs have increased both costs of food 
production and price volatility. Both 
higher  costs  and  higher  risks  have 
been  imposed  on  the  food  produc-
tion sector. 
At  a  minimum,  a  more  flexible 
biofuels policy that is responsive to 
agricultural and energy market reali-
ties should be preferable to the fixed 
tax credits, RFS and tariffs contained 
in EISA. An energy policy that more 
strongly emphasizes energy conserva-
tion and fuel production from non-
food  sources,  including  incentives 
to increase U.S. oil and natural gas 
production, could also be part of that 
debate. 
To solve the potential dilemma of 
“food vs. fuel” demands that we ef-
fectively  address  long–  term  energy 
consumption, production and prices. 
Failure to do so could lead to a fu-
ture of significant increases in global 
food and energy costs, a marked de-
cline in global living standards, and 
an increase in global poverty rates. If 
this happens the world will be neither 
a more independent nor secure place 
to live.
For More Information
Babcock, B. A. (2008). When Will 
the Bubble Burst? Iowa Ag Review. 
Winter 2008 Vol. 14 No. 1.
MSNBC  (2008).  As  food  prices  spi-
ral, farmers, others profit. Available 
online:    http://www.msnbc.msn.
com/id/24840735/. 
Rubin, O., Carriquiry, M. & Hayes, 
D.  (2008).  Implied  Objectives  of 
U.S.  Biofuel  Subsidies,  Working 
Paper  08–WP  459.  Ames  Iowa. 
Iowa State University. Center for 
Agricultural and Rural Develop-
ment.
Taheripour, F. and Tyner, W. (2007) 
Ethanol  Subsidies:  Who  Gets  the 
Benefits? Farm Foundation. April, 
2007
Tyner,  W.  (2008)  The  US  Ethanol 
and Biofuels Boom: Its Origins, 
Current Status, and Future Pros-
pects. BioScience. Vol. 58, No. 7 
(July/August 2008), pp.646–53
Thomas E. Elam (thomaselam@farme-
con.com)  is  President  of  FarmEcon 
LLC, Carmel, Ind.

Food or Fuel? Choices and Conflicts

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