Cornell University DEEP-GREEN-RADAR Faculty Associate Professor Fujin Yi's research using a structural econometric model of a dynamic game to analyze subsidies and mandates was presented at the Northeast Workshop on Energy Policy and Environmental Economics at Dartmouth and at the Stanford Institute for Theoretical Economics (SITE) session on Empirical Implementation of Theoretical Models of Strategic Interaction and Dynamic Behavior.
In his research, Professor Yi analyzes the effects of government subsidies and the Renewable Fuel Standard on the U.S. ethanol industry. His paper first develops a stylized theory model of subsidies which examines which types of subsidies are more cost-effective for inducing investment in firm capacity, and how the presence of a mandate affects the relative cost-effectiveness of different types of subsidies.
He then empirically analyze how government subsidies and the Renewable Fuel Standard affect ethanol production, investment, entry, and exit by estimating a structural econometric model of a dynamic game that enables him to recover the entire cost structure of the industry, including the distributions of investment costs, entry costs, and exit scrap values.
Professor Yi uses the estimated parameters to evaluate three different types of subsidy -- a production subsidy, an investment subsidy, and an entry subsidy -- each with and without the RFS. He evaluates the effects of government subsidies and the Renewable Fuel Standard on production, investment, entry, exit, producer profits, consumer surplus, net social welfare, average plant capacity, and market capacity.
Professor Yi uses a dynamic model because decisions of investment, entry, and exit are forms of decisions of investment under uncertainty: these decisions are at least partially irreversible, there is uncertainty over the payoffs to these decisions, and ethanol producers have leeway over the timing of these decisions. As a consequence, there is an option value to waiting that is best modeled with a dynamic model. Moreover, government policies may have important effects on entry, production, investment, and exit costs and decisions that a static analysis would overlook. Analyses that ignore the dynamic implications of these policies, including their effects on incumbent ethanol firms' investment, production, and exit decisions and on potential entrants' entry behavior, may generate incomplete estimates of the impact of the policies and misleading predictions of the future evolution of the ethanol industry.
Professor Yi uses a model of a dynamic game because an ethanol producerís payoffs are affected by the decisions of other producers in the market. As a consequence, firms behave strategically and base their production, investment, entry, and exit decisions on those of other firms in the market.
The theory model reveals the following tradeoff between production and investment subsidies. Although any investment induced by a positive production subsidy is investment that would not have occurred otherwise, the government must pay the production subsidy for each unit of production in both periods, including inframarginal units of production. In contrast, an investment subsidy must be high enough to induce investment that otherwise would not occur, but there is a cap to how high that minimum investment subsidy needs to be. The theory model also reveals a similar tradeoff between production and entry subsidies.
The theory results show that whether it costs more to the government to induce investment via a production subsidy or an investment subsidy depends on the parameters, even if there is also a mandate, and is therefore an empirical question. The theory results also show that, whether or not a mandate is present, it costs more to the government to induce investment via a production subsidy than via an entry subsidy. The empirical results show that the RFS decreased investment costs, increased entry costs, and increased both the mean and standard deviation of exit scrap values.
Conventional wisdom and some of the previous literature favor production subsidies over investment subsidies, and historically the federal government has used production subsidies to support ethanol. However, the results of Professor Yi's counterfactual simulations show that, for the ethanol industry, investment subsidies and entry subsidies are more cost-effective than production subsidies for inducing investment that otherwise would not have occurred. Professor Yi's results have important implications for the design of government policies for ethanol in particular, and more generally for renewable energy and socially desirable commodities as well.
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