The U.S. Biofuel Mandate and World Food Prices: An Econometric Analysis of the Demand and Supply of Calories

We show how yield shocks (deviations from a time trend), which are likely attributable to random weather fluctuations, can facilitate estimation of both demand and supply elasticities of agricultural commodities. We identify demand using current-period shocks that give rise to exogenous shifts in supply. We identify supply using past yield shocks, which affect current expected price through inventory accretion or depletion, thereby exogenously shifting the demand for new production. Our estimated supply elasticities are larger than the standard approach taken in the literature, which uses past prices to instrument for current prices. The problem with the standard approach is that past prices are endogenous to anticipated shifts in supply. Our instrument separates exogenous weather-induced price fluctuations from those stemming from forecastable variations in growing area. We use our estimated elasticities to evaluate the impact of ethanol subsidies and mandates on food commodity prices, quantities, and food consumers’ surplus. The current U.S. ethanol mandate requires that about 5 percent of world caloric production from corn, wheat, rice, and soybeans be used for ethanol generation. As a result, world food prices are predicted to increase by 30 percent and global consumer surplus from food consumption is predicted to decrease by 156 billion dollars annually. ♣ Department of Agricultural and Resource Economics, North Carolina State University, Box 8109, Raleigh, NC. Email: michael [email protected]. ♠ Department of Economics and School of International and Public Affairs, Columbia University, 420 West 118th Street, Room. 1308, MC 3323, New York, NY 10027. Email: [email protected]. Between the summers of 2006 and 2008, corn prices more than tripled from roughly $2.50 per bushel to nearly $8.00 per bushel. Prices for rice, soybeans, and wheat rose by similar or greater amounts. High prices for staple grains can cause hunger, malnutrition, and riots in developing nations. It has also been shown that weather induced income shocks increase civil conflict in Africa (Miguel et al. 2004). Since many countries in Africa are net food importers, an increase in the price of food is equivalent to a decrease in real income. It is hence important for policy makers to know the drivers of rising food prices. In this article we exploit yield shocks – deviations from country and crop-specific yield trends that are arguably due to random weather shocks – to estimate world supply and demand for the sum of edible calories derived from corn, soybeans, wheat, and rice. These four crops comprise about 75 percent of the caloric content of food production worldwide. We aggregate all four major commodities crops based on their caloric content. Agricultural commodity markets are often cited as the archetypal example of competitive markets, having many price-taking producers and buyers and well-developed spot and futures markets. The empirical challenge is to separate supply and demand curves in the market’s formation of prices and quantities. Correct identification requires instruments that shift one curve (supply or demand) in a way that is plausibly unrelated to shifts in the other curve. Since Wright’s (1928) introduction of instrumental-variable estimation, weather has been considered a natural instrument for supply shifts, which can be used to facilitate unbiased demand estimation. The idea is that weather shifts supply in a way that is unrelated to demand shifts. Surprisingly, the literature in agricultural economics that uses weather-based instruments for supply shocks to identify demand curves is extremely thin. In this paper we also show how weather-induced yield shocks can be used to identify the supply curve. Past weather shocks affect current inventories and thus expected future prices via storage. If past yield-shocks are bad and inventories are at low levels, the demand for new production goes up. In other words past weather shocks exogenously shift demand for current production in a way that is plausibly unrelated to current supply. In a second step, we use the demand and supply model of world commodity calories to examine the effect of biofuel mandates on food prices. The exceptionally large and unanticipated rise in prices between 2006 and 2008 has been attributed to ethanol as well as to the following other factors: First, rising oil prices have accelerated the demand for biofuels as an alternative fuel source. Second, there has been a sharp increase in the demand for basic Cassman (1999) attributes two-thirds of world calories to corn, wheat, and rice. Adding soybean calories brings the share to 75 percent.