The Cost of the Biofuel "Free Lunch"

Posted: Oct 13, 2007 12:01 AM
The Cost of the Biofuel "Free Lunch"

Economics teaches us that there is no such thing as a free lunch. Anyone that tells you differently is probably trying to sell you something. In this case, the “something being sold” is bio-fuels.

Bio-fuels, the transformation of corn, sugar, soybeans and other crops into motor fuels, have taken on a new sense of urgency due to, in part, the global warming consensus. Global warming advocates push regulations that mandate ethanol additives in cars, as well as other policies that encourage the U.S. to consume more bio-fuels. Furthermore, these policies are sold as a win-win policy that reduces the country’s overall carbon emissions and its reliance on foreign energy supplies. Not surprisingly, the federal government’s subsidization of the bio-fuels industry has increased.

The subsidies and regulations are designed to increase our efficiency, production, and use of bio-fuels. There are serious negative consequences from these policies, however. Subsidizing a favored industry is an old theory in economic development. For instance, Latin American countries practiced a type of industry subsidization for many years referred to as an “import substitution” strategy. The import substitution strategy states that new industries and companies (or infant industries as they are often referred to) need to be protected and subsidized. Without the protections and subsidies, the fear is that the domestic firm will never gain efficiencies, scale, and loyal customers because international competitors will enter the market and drive the infant industry out of business. The solution is to subsidize and protect the industry until the infant business grows up. Once the domestic industry has grown up, domestic businesses will be capable of successfully competing with international businesses on their own, and the subsidies and protections can be removed.

While this logic sounds nice in theory, the problem is that the infant never grows up! As practiced, the subsidies and protection of the domestic businesses never stop, the businesses never gain their promised efficiencies, and for the Latin American countries that implemented these policies, economic growth stagnated.

A similar parallel is occurring with respect to the U.S. subsidization of the bio-fuels market. The theory states that without government subsidization of the industry, the technology will never develop. Therefore, the government must subsidize the bio-fuels business in order to help the industry gain the necessary efficiencies. Once these efficiencies have been gained, the bio-fuels industry will be ready to successfully contribute an important carbon fuel substitute. The problem is that the bio-fuels industry has been subsidized for years and there is still no end to the industry’s largess in sight – even with oil at $80 a barrel.

Bio-fuel subsidies result from excessive lobbying from the bio-fuels industry just as much, if not more, than the true scientific merit of the technology. Consequently, we are missing out on the opportunity to judge whether bio-fuels are actually a viable future alternative fuel, and if so, to what extent. As such, society may be missing out on a more appropriate energy source in the future

Perhaps more importantly, the subsidization of bio-fuels is imposing a real and direct cost on people and the global economy in the here and now. When people’s demand for a product increases by more than its supply, prices rise. The growing subsidies and encouragement of bio-fuels use is increasing the demand for the source materials of bio-fuels: corn, sugar, soybeans and other crops at a faster pace than supply. Greater demand for agricultural goods is driving up food costs around the world. For instance, the price of corn is up 40% this year. The price of soybeans is up 75%. The price of wheat is up 70%. And, it is not just the prices of agricultural commodities. Higher prices for crops are increasing the prices of beef, pork, and chicken. According to the Bureau of Labor Statistics (the arbiter or consumer prices in the United States), while overall prices were rising 2.0% in August of this year, the prices of food and beverages were rising twice as quickly, at a rate of 4.2%. Rising food and grain costs are also squeezing many businesses, which can lead to lower profits, slower wage growth, more unemployment or a combination of these impacts should the squeeze continue.

Once these costs are recognized, it is difficult to describe bio-fuels subsidization as a win-win proposition. Instead, like everything else, encouraging the use of bio-fuels comes with a cost. Recognizing these costs is critical because in life, there is no such thing as a free lunch.