More notes

(In the main cut and pasted from elsewhere - the diagrams have not come out)

1) Should the EU be cutting import tariffs on cereals when many of the poorest countries in the world are suffering from cereal shortages and high prices?

The EU approach to the problem of food inflation was to reduce / eliminate the tariff on imports from the rest of the world. This would reduce prices by increasing supply. The additional supply would come not from domestic producers but from farmers outside the EU.

Thus you must draw a tariff diagram!

The EU approach, unlike the Russian approach, restores free market forces. It uses the price mechanisms rather than seeking to usurp the market. The Russian approach interferes with the market and leads to government failure, because of the significant unintended negative consequences. The EU approach leads to lower prices and increases in quantity. Moreover, by reducing protection for Europe’s agricultural industry it contributes to world trade by expanding rather than by diverting it.

2) Using economic analysis, evaluate the case for biofuel production

Paragraph 4 linking with extracts 4 (a) and 4 (b) introduces the notion of alternative uses for cereal crops. Given the farm surpluses that grew up under the CAP, biofuel crops were seen as useful in providing farmers with a new market for their cereal crops, while also making more productive use of their surplus capacity. At the same time, it was believed that biofuels will reduce the use of fossil fuel and, therefore, lead to a reduction in carbon emissions. Hence, biofuel production could be supported on environmental grounds.

Diagrams showing reduction of negative externalitieis

However, we learn in the second part of the extract that biofuels have contributed to the global rise in food prices and, at the same time, doubts have been expressed about the environmental benefits of these energy crops

Note that other crops (eg sugar cane) can be a more cost-effective source of bio-fuel, and provide a source of income for farmers in developing countries

3) ‘CAP is an example of government failure’ – discuss

CAP intervention in the market can be seen as an example of the law of unintended consequences, or of government failure.

Remember governments intervene to correct market failure but, equally, they can produce market failure. This is a situation where the actions of government lead to allocative inefficiency so that, instead of curing a problem, they add to a problem or, more likely, they correct one problem, only to create another.

In this case, the problem was instability of prices and the solution was buffer stock intervention in the market. This intervention led to the problem of allocative inefficiency through the overproduction of farm produce.

To correct the newly created problem, the EU then resorted to other measures such as milk quotas (to limit milk production) and set aside which provided farmers with an income for a proportion of their land which was left unused, that is farmers were paid not to produce certain crops in part of their land

4) Compare figs 1.3 and 1.4

Notice that these graphs refer to prices in the UK, but we assume that the trend in UK prices are replicated in the rest of the EU.

The former graph refers to the price of feed wheat in the UK. Feed wheat is not wheat sold to the consumer market but wheat sold as a farm input to feed cattle and other farm animals.

You can see that there is an upward trend in the curve in Figure 1.3. The rise is slow at first (and there are times when the price is stabilised and, even, falling), but it speeds up in the third quarter of 2007. Over the two years as a whole, the trend is upwards. This would be apparent if we smoothed out the curve by using moving averages to reveal the trend. But, notice that there is a distinct dip in prices in the closing months of 2007 (similar to the dip in EU butter prices at the same time).

Although it is not possible to be certain of the cause of the dip, we can assume that the price movement reflects changes in global supply and demand. Overall, the price of feed wheat has doubled over this period of nearly 2 years.

The lower graph refers to the price of another farm input – fertiliser but, again, in the UK. Fertiliser is important even in dairy farming since fertilisers are used to increase the yield per acre of grass which is a vital feed for dairy cattle. A similar trend to the one revealed with respect to feed wheat can be seen in the price of fertiliser. For much of the two year period the price is static but seems to rise steeply from March 2007. Over the two years as a whole, the price has risen from around £146 per tonne to £185 per tonne – a rise of around 27%. The only significant difference between Figures 1.3 and 1.4 is that in the latter graph, the price does not dip down at the end of the two year period.

It should be noted that the written text of Extract 2 is dated 29th March 2007. This press release informs us that the 6,091 tonnes of butter held in the EU buffer stock scheme will be sold off and that EU purchase of butter under the intervention scheme, will cease. We can see the impact of the decision in Figure 2.1 below which shows the quantity of butter held as intervention stock. This fell from over 120,000 tonnes in the summer of 2007 to zero by July 2007.

The release of butter from the intervention stocks would have increased the supply of butter in EU markets and, other things being equal, might have contributed to the dip in EU wholesale butter prices that we detected in Figure 1.2 in February. At this stage we can analyse the causes of the movement of EU wholesale butter prices by combining conclusions from Extracts 1 and 2 as follows:

1. A rise in global demand for foodstuffs, including butter, led to the price rise (a rightward shift of the demand curve).
2. A rise in the price of farm inputs reduced willingness to supply, thus further pushing up food prices (a leftward shift of the supply curve).
3. But, the release of butter from the EU intervention (buffer) stocks led to a slight reduction in wholesale prices towards the end of the year. It is surprising that there was a 7 month time lag from March until Oct 07.

5) Explain the divergence between the trends in world and EU prices of butter. Is the main reason the falling price of feed wheat?

Extract 1 Figure 1.1 concerns the world wholesale price of butter. Notice that it is a wholesale price rather than the retail price that consumers pay when they buy butter from supermarkets. The lower curve refers to 2006 while the upper curve refers to 2007. (To make the distinction clearer it is advisable to use different coloured highlighter pens to distinguish between the two curves and avoid any confusion between the two). It might be puzzling to see the two curves depicting the two years shown one above the other. In effect, the upper (2007) curve should be tacked on to the end of the 2006 curve. Notice that both seem to begin at the same price. This is simply because after falling in the first half of 2006, the price returns to its January 2006 level.

We can interpret the graph as follows:

• In 2006 the world wholesale price of butter fell gradually in the first half of the year, but rose gradually in the second half of the year to return to its January level.
• In 2007 there was a continuous rise in prices (albeit at differing rates throughout the year).
• Over 2007 as a whole, the wholesale price rose from just under $2,500 per tonne to just under $4,500. This represents a rise of around 80% over the year.

The lower graph (Figure 1.2) shows the wholesale price of butter in the EU. Notice that the data is expressed in units which are different from the graph of world prices. The currency used is the euro rather than the dollar, and the unit of weight is kilograms rather than tonnes. Although the world and EU graphs are not comparing prices on exactly the same basis, the EU graph shows some similarity with the world graph but with one crucial difference.

We can interpret the EU graph as follows:

• Prices fell in the first half of 2006 but returned to around their January level by the end of the year.
• After a small first-month fall, prices rose in the first three quarters of 2007.
• The rise was steepest in the summer months of June, July and August.
• From January to October prices rose from just under 2.6 euros per kg to just under 4.2 euros per kg. This was a rise of around 62%.
• But, in the final quarter of the year the wholesale price of butter fell to 3.5 euros.

The divergence between the trends in world and EU prices of butter also needs to be explained. One possible explanation is the falling price of feed wheat in the Autumn of 2007. This is depicted in Figure 1.3 and, if we assume that it applies in the rest of the EU but not in the world outside the EU, then it might explain the Autumn 2007 dip in EU butter prices. However, the case - for this as the explanation - is weak because:

1. There is no evidence that the fall in feed wheat prices was EU wide, although a single market should produce a single price.
2. How do we explain the fact that feed wheat fell in price in the EU but not elsewhere?
3. The fall in the price of animal feed should have preceded the fall in the price of butter. It is unlikely that they would have occurred simultaneously.
4. We should bear in mind also that we do not know what proportion of butter prices reflects the cost of feed wheat.

A more likely explanation emerges in Extract 2.

6) Using diagrams explain why despite there being no big increase in demand in India and China for butter, prices still rise.

Logically, a rise in prices in a free and competitive market can be explained either by an increase in demand or by a decrease in supply, or a combination of the two (see Illustration 1 below).

Worldwide demand for food has increased as a result of:

1. rising population throughout the world.
2. rising living standards throughout much of the world.
3. industrialisation in developing countries, especially in India and China.
4. the resulting shift of resources to secondary and tertiary production.
5. a fall in the real price of food over many years, thanks to lower production costs arising from improved farm technology.

It might be argued that there is little or no Indian and Chinese demand for butter, but it should be realised that the development of these economies with their vast populations does increase the demand for land and other agricultural inputs and, therefore, has put upward pressure on prices.

The supply of butter to markets is affected by the weather (unplanned fluctuations in supply) and by the price of inputs. Adverse weather conditions will reduce supply and push up price. A rise in the price of inputs reduces the willingness of suppliers to supply the market at previous prices. The twin effect of rising demand and falling supply is shown in the diagram below thus pushing the price up from P to P1.







7) How was the buffer stock scheme justified when CAP was conceived?

The practice of buying up stocks of agricultural produce at EU intervention prices is an example of a buffer stock scheme and was justified when CAP was first conceived, in terms of:

1. price instability in agricultural markets. A combination of unplanned fluctuations in supply and inelastic demand leads to major price fluctuations.
2. the need for food security.
3. the social case for preserving the agricultural way of life.
4. the political power of the agricultural lobby in certain EU countries. This is a fact of life although it should not be seen as an economic argument for agricultural support.

Indeed, these features explain the reluctance among major EU countries for CAP reform, in spite of the unarguable welfare benefits.The system of buffer stock intervention in markets was designed to achieve price stability and ensure that farmers receive a price above the free market price for their produce.

Under the CAP there were three prices:

1. The market price - which was the result of the interplay of market forces.
2. The target price - which was the price that EU ministers and officials considered to be appropriate for farmers to receive to ensure a reasonable standard of living.
3. The intervention price - which was the price at which the EU would buy up surplus foodstuff to place in intervention or buffer stocks. The intervention price was set below the target price in the expectation that it would not lead to overproduction. However, it was set above the free market price which would have cleared the market of any surplus if it had been allowed to prevail.

To prevent prices falling too far the EU bought up surplus stock at the intervention price. This was added intervention or buffer stock. In years of shortage, produce would be released from the buffer stock. This would increase the supply of goods on the market, thus moderating price. So, in essence, buffer stock purchases occurred during years of surplus and buffer stock sales occurred during the years of shortage (see Illustration 2). If we assume that there was a rough balance between years of surpluses and shortage then:

• Produce would remain in stock for only short periods.
• Stocks would not grow over the long run.
• The scheme would be self financing, since money raised from buffer stock sales would balance the money raised from buffer stock purchase.
• Prices would be stabilised ensuring that farmers received a fair price for their produce and would have stability to plan ahead.


P2 S1

Gvt sells stock Gvt buys up stock



Q2 Q Q1

8) Using economic analysis, argue the case against a buffer stock scheme.

Despite these theoretical benefits of buffer stock schemes they can be criticised from a number of angles.

Firstly, they can be criticised on grounds of equity. To ensure that farmers receive a price which provides them with a satisfactory standard of living, consumers are required to pay higher prices for farm produce. This would be the case in years of surplus.

The problem was intensified by the fact that under the Common Agricultural Policy, EU farmers were protected against competition from farmers abroad. This meant that EU consumers did not have access to lower world prices but had to pay higher EU prices. If, for instance, British consumers were forced to buy butter from mainland Europe rather than even cheaper butter from New Zealand, then the result would be trade diversion.

Remember, the conclusion from theory of customs unions is that trade creation increases economic welfare but trade diversion reduces it.

The second criticism of buffer stock schemes comes from the fact that such schemes stabilise prices but do not stabilise incomes. The income of farmers is a function of the price of produce and the quantity produced. If price is stabilised and there are no penalties for overproduction, then there is a direct incentive to overproduce. In fact this is what happened under the system of intervention prices.

Farmers increased their output in the full knowledge that any surplus would be bought up by the EU. So, rather than alternating between years of surplus and years of shortage, as implied by illustration 2, the system led to continuous surplus. This meant that the stocks built up over the long term leading to the infamous butter mountains and wine lakes. This unintended consequence was made worse by the slow but ongoing improvements in agricultural productivity. If intervention purchases become the norm, year after year, then rather than being self financing the scheme becomes a drain on the EU tax payer. In the 1970’s and 1980’s three quarters of the EU budget was spent on agricultural support to buy up produce that was not required by consumers. Moreover, as surplus became the norm, consumers were forced to pay higher prices than was justified. This system of overproduction of farm produce represented allocative inefficiency. Resources were used to produce goods for which there was no market.

9) How was CAP reform forced on the EU?

CAP reform has been a long time in coming because of the vested interests of European farmers but was forced on the EU by:

1. The continuing high cost of the system.
2. The increasing importance of other EU wide priorities.
3. The reluctance on the part of EU members to contribute more to the EU budget.
4. The continuing decline of agriculture as a share of EU output.
5. Resentment from the rest of the world to European protection.
6. The need to reduce farm protection in order to liberalise other aspects of world trade.
7. The entry of Poland and other Eastern European countries. With such a large agricultural population it was inevitable that there had to be a reduction in the system of farm support.

As part of the reform of CAP the buffer stock system for butter was ended. Not only were stocks released, but it was announced that intervention buying will now cease in the EU. This should be seen as a measure which restores the free market in butter, at least within the EU.

10) From paragraph 3 of the introduction, contrast the interest rate policy approach with the German welfare benefits scheme?

“German left wing politicians have called for an increase in welfare benefits so that people can cope with price rises”. This can be regarded as a coping strategy – it enables the less well off (ie the people who are hardest hit by food inflation) to cope with the problem. However, it merely masks the problem rather than tackling it and there is an opportunity cost involved. It is the equivalent of a pain-killer which deadens the pain but leaves the medical condition unchanged. The rise in welfare payments will benefit the less well off and, in this sense, it could be said to be targeted assistance. However, people other than benefit recipients derive no benefit from this measure and, in addition, might be adversely affected by a tax rise to pay for the higher level of benefits, or a shift in government priorities away from other programmes. Therefore, welfare benefits not only disguise the problem but redistribute income. The only positive aspect of the policy is that it is a targeted measure.

The introduction also refers to the use of interest rate policy to combat inflation (lines 14-15 of paragraph 3). We know that monetary policy, in the form of interest rate changes, are now the prime weapon in controlling inflation. But, this is inflation in general rather than food inflation. Food inflation is not caused by cost push or demand pull within the countries of Europe but, instead, is global. Food inflation is the result of global supply and demand and not just UK or EU supply and demand. If interest rate policy is used to combat an inflationary problem which is limited to food, then high interest rates will be inflicted on the economy as a whole. Not only would such measures be ineffective on global food prices, but also they would be damaging to the economy as a whole.

11) Evaluate the EU scheme to drop tariffs.

The CAP had two basic strands:

1. Buffer stock intervention in the market
2. Protection in the form of controls on the import of food.

The EU solution to food inflation is to “drop” import tariffs on certain foodstuffs. It is unclear from the extract if ‘drop’ means to reduce the level of the tariff, or whether it means to eliminate the tariff altogether. Either way, the graphical analysis of the move is the same and it is shown in Illustration 3b. What we have here is the standard analysis of tariffs, but we need to remember that rather than raising tariffs we are talking about reducing / eliminating them.

Domestic Supply

P1 World Supply plus tariff
Loss of Tax
d c Revenue b a
P2 World Price


Q1 Q2 Q3 Q4 Q
Reduction in domestic production

We start at price P1 which is the world price plus tariff. This means that food on the EU market sells at this price which is higher than the world price that would apply in the absence of import controls. The quantity sold at the artificial price is Q3 and this is made up of an element equal to Q2 (which is supplied by domestic producers) and an element equal to Q2-Q3 (which is imported). When we remove the tariff we find that:

1. Price drops to P2.
2. The quantity supplied and demanded extends to Q4.
3. Domestically produced supply falls from Q2 to Q1.
4. Imports rise from Q2-Q3 to Q1-Q4.

In essence, when the price falls the quantity bought and sold increases, but the increase takes the form of increased quantity from abroad and a reduced quantity from domestic producers.

We can extend our analysis by considering the areas indicated by lower case initials in the diagram:

• The area a+b+c+d is the increase in consumer surplus resulting from the cut in tariffs.
• Area d is the reduction in producer surplus resulting from a lower price and quantity. This surplus is captured by consumers.
• Area b represents the loss of tax revenue for the state (in this case, the state takes the form of the EU which receives all tariffs and levies on goods imported from outside the EU). This loss to the state is transferred to consumers as consumer surplus.

This demonstrates that the reduction in tariffs benefits the consumer (and indeed world producers) at the expense of the domestic producer and the state (EU).

Conclusion: A reduction in tariff protection reduces prices to consumers and, unlike maximum price controls, does not reduce the quantity available for consumers to purchase. As such, it increases consumer surplus. Admittedly, there is a price to be paid for the tariff reduction. That price is paid by the state (EU) in the form of a reduction in revenue, and by domestic producers in the form of a reduction in sales. A tariff reduction makes use of the market rather than seeking to interfere with the market mechanism.

12) Why was the biofuel scheme promoted?

Extract 4 introduces us to additional explanations for rising food prices. We are told in 4a that rising food prices are partly the result of rising demand, especially from India and China, and partly the result of extreme weather conditions which impact on the harvest, and partly production switches to bio-fuels. But, there is another and very different explanation, and this relates to world oil prices.

Extract 4a & Figure 4.1: Global Food Crisis and World Oil Prices

Figure 4.1 shows world oil prices rising significantly from Jan 2007 (when they stood at $50 per barrel) to nearly $90 per barrel in Nov of that year, a dramatic 80% increase. You may remember that, at that time, the UK price of petrol at the pump rose to significantly over £1 per litre of petrol.

But what has this to do with the price of agricultural products? The answer is that the high and rising price of oil provided an incentive for farmers to grow cereals, not for human or animal consumption, but to convert into so called biofuels. We can analyse this in terms of supply and demand as follows:

• The high price of oil increased the profits from converting cereals into biofuel.
• Farmers responded by increasing the supply of biofuel crops at the expense of crops for food, in other words, the market mechanism shifted resources away from food production towards biofuel production.
• This increased the supply of biofuels, but at the expense of cereals as a food product.
• The decrease in supply (shown in illustration 4a) pushed up the price of food.

£ S1





In essence farmers were busy producing “food for machines” rather than food for either humans or animals. You will remember that in Figure 1.3 in the stimulus material we saw a steady rise in the price of feed wheat. This might be explained in terms of the switch to bio-fuel.

It is interesting to note that, in agricultural markets, while there is normally a time lag between a price signal and the ability to respond with a change in supply leading to price volatility, the switch of the same product to bio-fuel use generates a comparatively quick supply switch response at harvest time.

It is important to realise that not all farmers are producing biofuel but there has been a significant shift towards cereals as biofuels. This is demonstrated by statistics included in Extract 4a. US farmers sold 14 million tonnes of maize as a biofuel for vehicles. This represents 20% of the total maize crop and took one million hectares out of food production. The USA is a major producer of maize and other cereals, but it is also a major consumer of such products. If American farmers are producing maize as a fuel for vehicles, then it is likely that the Americans would have to either reduce its food exports, or increase its food imports. Either way, it will distort the market and push the world price of maize up. Unfortunately, the people who would suffer most from the changes in the market are the poor consumers, particularly in developing countries; maize farmers in poorer countries and, indeed, some food farmers in poorer countries will have done quite well.
But surely biofuels are a “good thing”? Until recently the production of biofuels was considered desirable for two reasons:

1. Firstly, with an alternative use for surplus cereal crops, biofuels provided a useful outlet for farm production. The growing of wheat for much wanted biofuels was surely better than the EU buying up surplus stocks in the much criticised buffer stock system which produced grain mountains. It was also better than paying farmers not to produce crops under the set-aside system (below).

2. Secondly, there is grave concern over the environmental damage inflicted on the planet through carbon emissions from burning fossil fuels. If biofuels inflict less damage on the environment, then there is much to be said for switching to the production of biofuel crops.

This takes us into an analysis of negative externalities, which are the subject matter of 4b.

Extract 4b: EU Biofuels Policy

In essence, this statement deals with why and how the EU promotes the production and use of biofuels. Biofuel production is promoted in order to:

1. diversify fuel supply sources (which is a code for reducing Europe’s dependence on Middle Eastern oil and Russian gas).
2. diversify income and employment and thereby slow down depopulation in rural areas by creating another market for EU grain and other farm products.
3. develop a long term replacement for non renewal fossil fuels.
4. reduce greenhouse gas emission.
5. help fulfil the commitment under the Kyoto Protocol to reduce carbon dioxide emissions by 8% by the end of 2012.

In the past, the EU sought to promote the production of biofuels by allowing cultivation to occur on set-aside land. This was land, up to an authorised percentage, that was taken out of crop production to prevent over production. As we saw in relation to the butter mountain, what happened was that the EU bought up surplus cereals at intervention prices and placed the grain in a buffer stock. This encouraged farmers to overproduce in the knowledge that they could sell any surplus at a guaranteed intervention price. With growing grain mountains the EU was forced to take corrective action which, in the case of grain, took the form of land set-aside. This meant paying farmers not to produce certain crops on the land that was set aside. The ban on production on set aside land only applied to certain crops, but this meant that set aside land could be used for the growing of other crops, such as cereals for biofuels. Farmers received set aside money and could sell the produce from the land. For instance, they could plant oilseed on set aside land, provided it was used as a biofuel and was not used in food production, either for animal or human consumption.

In 2003 the EU decided to provide an increased incentive to farmers to grow biofuels. This involved the use of land other than set aside land. A subsidy of 45 euros per hectare was given to farmers who used non set aside land for the production of so-called energy crops. This is a straightforward subsidy which can be analysed by economists using the standard supply and demand analysis of subsidies (see illustration 4b).

£ S

S (with subsidy)




Q1 Q2
The standard analysis of production subsidies is the reverse of that for the incidence of indirect taxation. The supply curve is shown as shifting to the right indicating that with a subsidy suppliers are willing to supply more at each price level. This increase in supply not only reduces the market price, but also causes the quantity bought and sold to rise from Q1 to Q2. The subsidy per hectare is represented by the vertical distance between the two supply curves

13) Using economic analysis evaluate the Crutzen case.

We know that the environmental case for this policy is based on the belief that biofuels produce substantially less carbon dioxide emissions than fossil fuels. We also know that the EU has a goal of replacing 20% of diesel and petrol by alternatives such as biofuels. This being the case, you would think that environmentalists would favour the development of biofuels. However, this is not the case according to George Monbiot the author of the article which is used in the lower box of Extract 4b. George Monbiot is a well known writer on environmental issues, but he is casting doubt on the idea that biofuels are environmentally friendly.

The second passage in Extract 4 (b) starts off by stating that “Biofuels offer a means of avoiding hard choices. They create the impression that government can cut carbon emissions and keep expanding the transport networks”. This will satisfy the business and motoring lobby and, at the same time, reduce carbon emissions. In other words, we can all do more motoring provided we switch from petrol and diesel to biofuels.

However, the second passage is headed the hidden costs of biofuels and in it we find that Paul Crutzen, a Nobel prize winning scientist, argues that the scientific analysis of biofuels fails to take into account all the environmental or external costs of the use of biofuels. You will notice that the scientific argument becomes quite involved and, as students of Economics, we are not equipped to argue the case on purely scientific grounds (especially with such an eminent scientist). However, we do need to understand the essence of the Crutzen case, and its economic implications.

Professor Crutzen’s case is that previous scientific analysis of the use of biofuels only considered the environmental impact of the burning of biofuels. It fails to take into account the environmental impact of producing biofuel crops and, in particular, the contribution to greenhouse gases of nitrogen fertiliser. He argues that these fertilisers generate a greenhouse gas (nitrous oxide) which is nearly 300 times as powerful as carbon dioxide. The total environmental impact from rapeseed oil (that is the production and burning of this biofuel) is 1 to 1.7 times the impact of diesel. The question arises as to how this compares with other bio-fuels eg maize? Are some bio-fuels still less damaging than oil based fuels?

This should remind you of the nature of cost-benefit analysis that you would have encountered early in the course. Remember, cost-benefit analysis compares total social benefits with total social costs, but one problem we face is in identifying and evaluating all the external costs and benefits.

Crutzen is arguing that previous studies failed to identify all the external costs associated with biofuel. If we are able to identify and measure all the costs involved we find that, rather than reducing environmental problems, the article alleges that bio-fuels actually add to it.

A parallel that can be drawn from this analysis concerns the importation by air of tropical and sub tropical fruits, out of season crops and flowers from countries such as Kenya, Morocco and Israel. Critics argue that the cost of importation should include the “food miles” involved and that if we want these tropical and ‘out of season’ crops we could grow them in greenhouses in Western Europe. We could have fresh tomatoes throughout the year without adding to global warming. But to use the phrase that headed the second passage, the hidden environmental cost of the greenhouse production of these crops in Europe is the environmental costs of heating greenhouses and using fertilisers.

As stated above, we are not in a position to argue the scientific case for and against biofuels, and you will not be required to do so in the examination. But, as economists we can analyse the economic case for and against biofuels. As this topic is primarily concerned with the economics of externalities it is essential that you include in your answer a sketch graph to show the impact of externalities (see Illustration 4c). This contrasts the conventional analysis (which suggests that biofuels are environmentally friendly) with the Crutzen analysis (which suggests that rather than producing less environmental harm, they produce more harm than conventional fuels). If this is the case, then the EU should reconsider the policy designed to promote the production of energy crops or biofuels.

Illustration 4c: The Welfare loss from Biofuels based on the Crutzen Analysis

£ S = Marginal social cost based on the
The welfare loss Crutzen view
from biofuels
S = Marginal social cost assuming that
external costs are zero or negligible

D = Marginal social benefit


The case against biofuels is that:

1. They add to pressure on arable land and water supplies.
2. They push up food prices, thus reducing the living standards of poorer people in Europe and in the developing world.
3. There are hidden costs which, if taken into account, destroy the environmental case for the switch to these crops.

The case for biofuels is that:

1. They are an environmentally sound alternative to fossil fuels.
2. They provide a new market for EU’s farmers.
3. The production of energy crops is a superior alternative to setting land aside or stockpiling in grain mountains.

14) Comment on the economic consequences of the production of energy crops to produce biofuel.

Fossil fuels pump carbon dioxide into the atmosphere and, therefore, cause global warming. Economists analyse this in terms of the market failure resulting from external costs. These costs are inflicted on the community and such costs are not taken into account by the market. As a result, these goods are over-consumed and underpriced. Biofuels are said to cause less pollution and, therefore, will enable us to continue to drive without causing the environmental problems associated with motoring. At the same time, the growing of energy crops for biofuels provides a further outlet for farm produce and is preferable to both import controls under the CAP, and other inefficient systems of farm support such as buffer stocks and set-aside.

The case against biofuels is that the full cost of biofuels should take into account the external costs of producing inputs such as nitrogen based fertilisers. If, as is claimed, the carbon emissions associated with producing as well as burning biofuels exceed those of fossil fuels, then the environmental case for biofuels is destroyed. The pessimistic view of biofuel is that they reduce economic welfare to a greater extent than fossil fuels.

We can use the textbook sketch graph of production externalities to illustrate the economic consequences of the carbon emission.

The supply curve on the right is the market supply curve, which is based on calculations of purely private costs. We are assuming that there are no external costs and, therefore, the marginal social cost is equal to the marginal private cost. However, the assumption of zero external costs cannot be sustained in the real world – all production will have some external costs. If external costs are taken into account, then marginal social costs (private and external costs combined) would result in the supply curve to the left.

Notice that the right hand supply curve (which ignores externalities) leads to increased output and lower prices, but at the expense of the community and the environment. The overproduction of goods results in a loss of economic welfare shown as the shaded triangle. But which of the two supply curves relates to biofuels? The optimistic view is that external cost of burning biofuels is negligible and, therefore, the right hand curve depicts the situation. The Crutzen view is that Biofuels involve a substantial external cost and, therefore, the left hand curve is a truer depiction of the situation. In fact, if biofuels produce more carbon emissions than the burning of fossil fuels, then the curve should be set to the left of that for fossil fuels. Policymakers would conclude from this analysis that rather than subsidising biofuels, they should be taxing them for the pollution done to the environment.

In addition to the environmental concerns there is the impact of the growing of energy crops on world food prices. The switch of resources to the growing of energy crops uses up vital water resources and adds to inflationary pressure on food prices. Hence, biofuels harm the least well off members of society, especially in poorer countries.

As economists, we can analyse the economic consequences of biofuels but have to be guided by scientists as to the environmental impact. If Crutzen is correct in his scientific analysis, then biofuels reduce economic welfare to a greater extent than fossil fuels. Even if he is not correct in his scientific analysis we should be concerned about the impact of biofuels on the price of food, especially in relation to poorer countries.

Efficiency and economic arguments
According to a study by Drs. Van Dyne and Raymer for the Tennessee Valley Authority, the average US farm consumes fuel at the rate of 82 litres per hectare (8.75 US gallons per acre) of land to produce one crop. However, average crops of rapeseed produce oil at an average rate of 1,029 L/ha (110 US gal/acre), and high-yield rapeseed fields produce about 1,356 L/ha (145 US gal/acre). The ratio of input to output in these cases is roughly 1:12.5 and 1:16.5. Photosynthesis is known to have an efficiency rate of about 3-6% of total solar radiation[62] and if the entire mass of a crop is utilized for energy production, the overall efficiency of this chain is currently about 1%[63] While this may compare unfavorably to solar cells combined with an electric drive train, biodiesel is less costly to deploy (solar cells cost approximately US$1,000 per square meter) and transport (electric vehicles require batteries which currently have a much lower energy density than liquid fuels).
However, these statistics by themselves are not enough to show whether such a change makes economic sense. Additional factors must be taken into account, such as: the fuel equivalent of the energy required for processing, the yield of fuel from raw oil, the return on cultivating food, the effect biodiesel will have on food prices and the relative cost of biodiesel versus petrodiesel.
The debate over the energy balance of biodiesel is ongoing. Transitioning fully to biofuels could require immense tracts of land if traditional food crops are used (although non food crops can be utilized). The problem would be especially severe for nations with large economies, since energy consumption scales with economic output.[64]
If using only traditional food plants, most such nations do not have sufficient arable land to produce biofuel for the nation's vehicles. Nations with smaller economies (hence less energy consumption) and more arable land may be in better situations, although many regions cannot afford to divert land away from food production.
For third world countries, biodiesel sources that use marginal land could make more sense, e.g. honge oil nuts[65] grown along roads or jatropha grown along rail lines.
In tropical regions, such as Malaysia and Indonesia, oil palm is being planted at a rapid pace to supply growing biodiesel demand in Europe and other markets. It has been estimated in Germany that palm oil biodiesel has less than 1/3 the production costs of rapeseed biodiesel.[66] The direct source of the energy content of biodiesel is solar energy captured by plants during photosynthesis. Regarding the positive energy balance of biodiesel[citation needed]:
When straw was left in the field, biodiesel production was strongly energy positive, yielding 1 GJ biodiesel for every 0.561 GJ of energy input (a yield/cost ratio of 1.78).
When straw was burned as fuel and oilseed rapemeal was used as a fertilizer, the yield/cost ratio for biodiesel production was even better (3.71). In other words, for every unit of energy input to produce biodiesel, the output was 3.71 units (the difference of 2.71 units would be from solar energy).
Biodiesel is becoming of interest to companies interested in commercial scale production as well as the more usual home brew biodiesel user and the user of straight vegetable oil or waste vegetable oil in diesel engines. Homemade biodiesel processors are many and varied.

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