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Sunday, September 30, 2007

An Externality and Ethanol

The one thing we're constantly warned against in class is externality abuse. Considering our rather stringent definition for that particular form of market failure, one which requires that it not only be a non-market interdependence, but also an unintentional result of the original transaction, the options for actual cases are rather sparse. However, there is one classic example in the form of pollution, specifically from cars. Such an example fits because the original transaction between the buyer and seller is for the gasoline, and the resulting air pollution generated by running the car is not a factor for either party but has long been assumed to harm other individuals. Assuming, as we do as economists, that efficiency is our goal, perhaps there is a role for government to play.

The most highly touted solution, as of late, is the alternative fuel ethanol. Not surprisingly the government plays at least two major roles in the availability of this product.

First, and perhaps most notably, ethanol is the beneficiary of major government subsidies in order to drive it's naturally high price down to the levels of gasoline. One may view this as a corrective subsidy but the idea seems somewhat specious to me. It should be noted, ethanol is still a producer of pollution, and thus exhibits a negative externality as well, just less of one then gas. As economists we don't subsidize negative externalities even if they're less negative then the alternatives, we apply corrective taxes in search of efficiency.

Second, the United States has restricted itself to corn ethanol, rather then the sugar alternative. Disallowing a product rather than allowing the market to act is never in the best interests of efficiency, and it's perhaps more demonstratibly so with ethanol because by all accounts the sugar version is the better of the two, requiring less input for the same output.

So has the negative externality associated with gasoline's air pollution been dealt with by government intervention? It certainly wouldn't appear so, instead we must now contend with the original market failure and the inclusion of a government failure.

-Jaeson Madison

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