The Effects of Market Power on the Size and Distribution of Benefits from the Ethanol Subsidy

Agricultural Issues Center
University of California

August 2007






The Effects of Market Power on the Size and Distribution of
Benefits from the Ethanol Subsidy




Tina L. Saitone, Richard J. Sexton and Steven E. Sexton1




















1Tina L. Saitone is a graduate student researcher in the Department of Agricultural and
Resource Economics, University of California, Davis. Richard J. Sexton is a professor in
the Department of Agricultural and Resource Economics, University of California, Davis.
Steven E. Sexton is a graduate student researcher in the Department of Agricultural and
Resource Economics, University of California, Berkeley.

Supported in part by the Agricultural Marketing Resource Center

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The Effects of Market Power on the Size and Distribution of Benefits from the
Ethanol Subsidy



Tina L. Saitone
Agricultural and Resource Economics Department
University of California, Davis
saitone@primal.ucdavis.edu


Richard J. Sexton
Agricultural and Resource Economics Department
University of California, Davis
rich@primal.ucdavis.edu

and

Steven E. Sexton
Agricultural and Resource Economics Department
University of California, Berkeley
ssexton@are.berkeley.edu



August 5, 2007

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The Effects of Market Power on the Size and Distribution of Benefits from the Ethanol Subsidy

Abstract: Market power is discussed frequently in debates about subsidies for ethanol
production, and structural conditions in the industry create a case for concerns about market
power. This paper develops a prototype model for determining the production and price impacts
and distribution of benefits from the U.S. ethanol subsidy when upstream sellers in the seed
sector and downstream buyers in the processing sector may exercise market power. The impact
of the subsidy is analyzed within a simulation framework for alternative levels of market power.
Results demonstrate that the impacts on prices and output are limited for modest departures from
competition. Distributional impacts are much greater. Seed producers and corn processors with
market power are able to capture relatively large shares of the benefits from the subsidy.

Key Words: corn ethanol, market power, oligopoly, oligopsony, subsidy


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Biofuels have generated a great deal of interest among developed and developing countries as a way to
simultaneously reduce imports of petroleum and air pollution caused by the combustion of fossil fuels.
Heightened concerns about global climate change, expanding demand and increasing oil prices, and
instability in oil-exporting countries have led to considerable efforts in the U.S., Europe, India, China,
and Australia to promote biofuels as an alternative to fossil fuels. In the U.S. attention has focused
principally on ethanol derived from corn feedstocks.1 President George W. Bush proposed in his 2005
State of the Union address that ethanol could break the U.S. “addiction” to oil.

Since its inception, ethanol has been unable to compete with petroleum. Under current
production methods, ethanol costs $0.50 more per gallon to produce than petroleum. Therefore,
governments have resorted to extensive promotion programs to spur ethanol production. In the
U.S., the primary instrument of the federal government is a $0.51 tax credit per gallon of ethanol
produced. The total cost of ethanol subsidies in the U.S., including state and federal programs
affecting every level of the supply chain, which encompasses support for output, factors of
production, intermediate goods, and consumption, was estimated to be $5.1 billion in 2006, and
is predicted to rise to as much as $8.6 billion in the near term (Koplow).
The ethanol subsidy is intended to both promote the diffusion of ethanol and to support
farmers, who are believed to gain considerably through widespread adoption of ethanol produced
from corn. The farm lobby has supported ethanol subsidies as a top priority because they are
seen as a more politically feasible instrument than price supports, given the dominance of
environmental considerations in domestic policy. Though ethanol is believed to increase farm
income, it is recognized there will be winners and losers in agriculture. For instance, livestock
producers are expected to suffer because of high feed costs whereas corn producers will benefit.
Gardner (2003) compares the gains to farmers from such demand-inducing subsidies and

1 Brazil has generated considerable ethanol from sugar cane and the EU and India produce relatively large quantities
of biodiesel from soy and palm oil.

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regulation to traditional commodity promotion regimes and concludes that the strategy of the
National Corn Growers and other industry groups may be optimal given that they can rely on the
lobbying resources of ethanol producers.

Most of the literature analyzing agricultural policies assumes perfectly competitive
markets (McCorriston), with Gardner (1987) representing a prototype treatment.2 Gardner
(2003) also assumes perfectly competitive markets in his evaluation of ethanol subsidies.
However, the presence upstream of dominant seed producers like Monsanto and DuPont and
powerful grain processors downstream like Archer Daniels Midland and Cargill raises questions
as to whether the competitive paradigm is appropriate to model this industry and whether
analyses that rely upon it are able to capture the true size and distribution of benefits from
ethanol subsidies and regulation.
This paper develops a prototype model for determining the production and price impacts
and distribution of benefits from the ethanol subsidy when market power may be exercised
upstream from the farm in the seed sector and downstream in the corn-processing sector. It is
not the goal of this paper to estimate the extent of market power in the corn sector, although we
do offer evidence in support of the proposition that market power may be important. Rather, our
goal is to illustrate how upstream and downstream market power influences the market effects of
the ethanol subsidy and who benefits from it.

Our model draws upon the methods of Alston, Sexton, and Zhang (ASZ) and Gardner
(2003). ASZ developed a model of buyer and seller market power exercised by downstream
processing firms to determine the effect of imperfect competition on research benefits. Our
model extends the ASZ model by permitting the exercise of seller power upstream from the farm
sector and buyer power downstream in the corn-processing sector and by providing a specific

2The policy literature that does consider the effects of imperfect competition, generally assumes pure monopoly or
monopsony, which may no better represent industry structure than a model of perfect competition.

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application to ethanol subsidies. Substantial market concentration and subsidies observed in the
U.S. for ethanol production exist in other countries as well, so we might anticipate that the
results from this paper also apply broadly to other countries.
This paper proceeds with a brief background on ethanol and discussion of the industry
structure. The model of imperfect competition is then developed. The model is then
parameterized to approximate conditions for ethanol production in the U.S. and the impact of the
subsidy is analyzed within a simulation framework for alternative levels of market power. A
discussion of the results and possible extensions are offered in conclusion.

Overview of the U.S. Ethanol Industry
Since the oil crisis of the 1970s, ethanol has been touted as an alternative to fossil fuels. Today,
the technology is mature and demand for ethanol is growing. Ethanol is seen as a fuel extender,
an oxygenate replacement for the toxic MTBE, and a renewable fuel source that can replace
gasoline and reduce emissions of greenhouse gases. Federal and state policies are also driving
demand. The Federal Government has banned MTBE in areas that fail to meet federal air quality
standards, and many states have outlawed it entirely. In addition, the Energy Policy Act of 2005
(EPACT 2005) establishes a Renewable Fuels Standard that requires 7.5 billion gallons of
renewable fuel be used by 2012. The EPACT 2005 also reauthorizes a $0.51 tax credit per
gallon of ethanol production.

The net energy benefits (NEB) of corn ethanol are small. When analysis incorporates the
animal feed byproduct of ethanol production, the NEB is between 1.25 and 1.34 units of fuel
energy per unit of fossil fuel input (Hill et al.; Shapouri, Duffield, and Wang). Farrell et al.
estimate that ethanol reduces greenhouse gas emissions by 13 percent after accounting for
emissions during production. Under the assumptions of a continued upward trend in oil prices

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and a downward trend in ethanol production costs, a 25 percent renewable standard could reduce
U.S. energy expenditures by 2025 (Bernstein et al.).

Ethanol production proceeds by removing sugar from corn and other starchy crops with
enzymes and then fermenting the sugar to alcohol with yeasts. The process yields 2.8 gallons of
ethanol per bushel of corn and 17 pounds of distiller-dried grain solubles, a byproduct added to
livestock and poultry feed. An estimated five billion gallons of ethanol were produced in 2006
from 1.8 billion bushels of corn—more than 17 percent of the domestic harvest. This level of
production is expected to cost the federal government in excess of $2.5 billion for the output
subsidy alone.3

Current production capacity in the U.S. totals five billion gallons per year with another
two billion gallons of capacity under construction. Archer Daniels Midland (ADM) owns in
excess of 1 billion gallons of capacity. Verasun Energy Corporation, the next largest producer,
has less than one-fourth of the capacity of ADM. ADM has announced plans to dominate the
biofuels industry, with CEO Patricia Woertz describing the company as being “in a category of
one” (New York Times).

Indeed, ADM has been the poster child for those opposed to ethanol subsidies, ranging
from popular commentators, such as editorialists at the Wall Street Journal and Investor’s
Business Daily (Bandow), to distinguished economists such as Stiglitz, who claim that ADM is
the primary beneficiary of the subsidy. The benefits of the subsidy are distributed among
participants in the market chain even under the competitive paradigm based upon standard
tax/subsidy incidence analysis, but it is not clear that as a competitive buyer and seller ADM
could retain much, if any, of the subsidy benefit instead of passing it forward to downstream
buyers or backward (as hoped by politicians) to corn farmers. Thus, those who argue that ADM

3 Twenty-three states also provide production subsidies, though the bulk of support comes from the federal
government (Koplow).

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is a primary beneficiary of the subsidy ascribe, at least implicitly, to a model where ADM
exercises market power in its procurement, sales, or both.
If we broaden the product market category to include all wet corn processing (the
category most relevant to questions of oligopsony power in corn procurement), the four leading
firms, ADM, Cargill, Staley, and CPC International, held a combined 74 percent market share in
1997 (MacDonald and Denbaly). Although markets for processed corn products would tend to
be national or international in geographic scope, the farm market for procurement of corn is
localized due to high shipping costs, meaning that concentration in relevant procurement markets
is higher than the national figures indicate.4
These levels of concentration, especially in light of the relevant geographic markets for
procurement, are consistent with the possible exercise of unilateral market power by processors
purchasing corn from farmers. In addition, market power may be attained or enhanced through
collusive behavior. It is significant in this latter regard that ADM was convicted recently for
colluding to fix prices to buyers of corn products (Connor).5 Thus, the downstream industry’s
high concentration, localized farm procurement markets for corn, and track record of collusive
behavior give reasons for concern that corn-products manufacturers may exercise market power
in procuring the raw product from farmers.6

4 The linkage between concentration and market power has long been controversial. The widely cited book by
Connor et al. classified food processing industries with four-firm concentration ratios (CR4) of 80% or more as
“shared monopolies”, 65 ? CR4 < 80 as “highly concentrated oligopolies”, 50 ? CR4 < 65 as “moderately
concentrated oligopolies”, and 35 ? CR4 < 50 as “low-grade oligopolies”. Although Connor et al. were concerned
with seller power, presumably they would apply their classification to buyer power as well, with the caveat that
national concentration rates understate the true level of concentration when procurement markets are local or
regional in geographic scope.
5 Although Cargill was not implicated directly in these price-fixing cases, Connor argues that considerable evidence
suggests Cargill’s involvement with ADM in arrangements to fix price.
6 Although the extent of concentration in the corn processing sector is also consistent with the exercise of oligopoly
power in the sale of corn products, we assume perfect competition in ethanol sales to simplify the analysis, and
focus on the implications of oligopsony power by the processors in procurement of corn from farmers. Powerful
downstream buyers likely could countervail attempts by corn processors to exercise oligopoly power. This focus is
also consistent with the recent report by the U.S. Federal Trade Commission which concluded that ethanol sales
were likely to be conducted on a competitive basis.

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Upstream, four firms, DuPont, Monsanto, Novartis and Dow, accounted for 69 percent of
corn seed sales in the U.S. (MacDonald and Denbaly). Sixty percent of the 2006 corn crop was
planted using genetically modified seed, and the percentage is expected to continue increasing.
Consistent with the literature on research and development, intellectual property rights, and
innovation, growing reliance on genetically modified seed can be expected to increase corn seed
industry concentration (Phillips 1956, 1966; Mansfield 1962, 1983; Winter; Swann and Gill;
Barton; Rosen). R&D generally allows large firms to extend their profit advantage over smaller
firms (Rosen). Because innovating firms are conferred limited monopoly status by intellectual
property rights, they will attempt to capture the benefits of their innovations through monopoly
pricing. In the context of innovation by suppliers of agricultural inputs, benefits that are
commonly believed to accrue to consumers and farmers, may be largely captured by innovating
firms (e.g., Moschini and Lapan).
In sum, concentration in the essential upstream corn seed sector is high and consistent
with seller oligopoly power. Further, the extensive use of protected GM seed traits confers
additional monopoly power to the innovating seed producers, raising the question of whether and
to what extent sellers upstream from the farm sector may be able to capture benefits from the
subsidization of ethanol production.


The Model
To enable the model to be as general as possible in terms of its depiction of alternative levels of
upstream and downstream competition, we seek to simplify other aspects of the model. We
assume that corn seed is used in fixed proportion in corn production, and without further loss of
generality, through choice of measurement units, set the Leontief coefficient to 1.0 for

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converting corn seed to corn production. We assume homogeneous farmers, and specify the
representative farmer’s profit maximization problem as:

Max ? = pq ? Pq ? c(q), (1)
{q}
where p is the farm price for corn, P is the price for seed, q is the individual farmer’s corn
output and seed input, and c(q) represents costs for other inputs into corn production that do not
necessarily enter production in fixed proportion. We assume c '(q) > 0, and c ''(q) > 0. The first
order condition is

( p ? P) = c '(q). (2)
1
To obtain analytical solutions and provide a platform for simulation, let
2
c(q) =
?q .
2
Then c '(q) = ? q, and p = P + ? q defines the individual farmer supply relationship. Solving for
p ? P
q, we obtain q =
,
?
which defines the direct supply relationship for the representative
farmer. Aggregating over n homogeneous farmers, the industry supply in the corn market is
n
p ? P

Q = ? q = nq = n
. (3)
i
=
?
i 1
Production is increasing in output price and number of farmers and decreasing in seed price and
the marginal costs due to other inputs. Given fixed proportions between corn seed and corn
production, (3) also represents the input demand for seed.
We also assume a constant marginal cost, w, of seed production, which represents the
seed industry’s supply curve in the case of perfect competition. The corn price is exogenous to
the individual producer but is endogenous at the market level. In the absence of the ethanol
subsidy let the aggregate farm-level demand for corn for all uses be represented by the linear
function:

Q = a ? b .
p (4)

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