Biofuel regulation and price

The New Zealand governments biofuel regulation has just come back from select committee. The Hive makes the excellent point that some of the changes to the bill may breach WTO rules. However, my focus here will be on the biofuel regulations impact on prices.

There has been a lot of talk about how mandatory biofuel sales will impact on prices, ranging from a 6c/lt increase to a 4c/lt decrease in prices (*).

Now the first thing to ask when looking at the biofuel regulation and prices is, how will it impact on the fuel companies “marginal cost”. The fuel company will set the price such that it makes the highest profit it can – as a result they will want to set marginal cost (the cost of selling one more unit) equal to the marginal revenue they receive (the return from selling one more). As marginal revenue is falling as we decrease the price there will be some point where they are equal – so the question remains, how could this impact on marginal cost?

I think the answer is that it doesn’t, the marginal cost of selling a litre of petrol will still be the same. Sure having to install a bunch of new infrastructure may be expensive, but this is an increase in fixed costs – the firm will have no incentive to pass this on to consumers, as it should be setting prices at a level that maximises profit.

However, this answer ignores a bunch of extremely important points.

Firstly, biofuel and normal fuel are different goods, with different marginal costs.  As a result, if selling a litre of biofuel is more expensive then the price of “fuel” will increase, if selling a litre of biofuel is cheaper the price could potentially decrease.

How does this work?  Well biofuel and normal fuel are substitutes, so the higher the price of one the greater the demand for the other.  As a result, if petrol stations have a mandatory target of biofuel, and if biofuel has a higher marginal cost, they will have to “cross-subsidise” biofuel by increasing the price of standard fuel.  This implies that no matter what fuel you buy, you will have to pay a higher price at the pump.

However, if the marginal cost of biofuel is lower, but the fixed costs of establishing the infrastructure are high, it is possible we might end up with LOWER fuel prices from this regulation.

How?  Well, if the fixed costs are high, firms may not be willing to enter the industry by investing in the infrastructure.  However, if they are forced to enter, then the fact that the marginal cost of selling biofuel is lower than standard fuel will lead firms to sell a whole bunch of biofuel, compete, and drive down prices.  The reduction in demand for standard petrol will also decrease the price of that – leading to straight out lower prices.

These fixed costs have to matter somehow!

Good point, fixed costs are still important for something – entry!  If petrol companies have to sell a certain amount of biofuel, and there are huge fixed costs for setting that up, then they are not going to set up the “marginal” petrol stations.  As a result, this will reduce, or limit the increase of, the density of petrol stations.  This reduction in effective competition, in an industry that is especially responsive to spatial competition (the main area of difference between petrol stations is where they are placed!) could have the long run impact of increasing fuel prices.

Of course, if we think the world is going to run out of oil any minute now, this consequence isn’t terribly important 😉

Conclusion

I’m not a fan of regulation, but I can understand that the government wants to do something to promote biofuels given the large fixed costs involved with their implementation.  (BTW, if they talk about “security of supply” or “the environment” they are talking out their asses – those are price and political issues, they are just trying to rehash externalities they have used for other policies to justify this one).

Personally, I would prefer a situation where investment in biofuel infrastructure was subsidised, such that the fuel companies could invest in biofuels once they feel they can gain security of supply and have a hold on the uncertainty in the industry – forcing them to do something just because the government would like it done at some point does not sound like the sort of policy that would give optimal outcomes.

I realise that the government is also interested in the “infant industry” view, that we could produce biofuels, but have to give the people upstream some security.  However, from what I’ve heard there is a large export market for biofuels brewing, with the Euro zone setting up mandatory biofuel regulations.  If the market is there the appropriate infant industry thing to do would be to subsidise the industry – not force downstream firms into a position where they have to rely on untested upstream firms that may be at a comparative disadvantage in the first place.

Overall, the policy could have been a lot worse (I’m glad the select committee knocked down the mandatory requirement levels!), but I think there could have been better solutions – but then again, maybe not 🙂 .  If anyone can provide me with some economic costings of the scheme I would be happy to see them, I’m open to being convinced that this scheme is genius.