Direct Subsidies

Direct subsidies are paid out of taxes. Ethanol produced in 2006 received $2.5 billion in direct subsidies paid to blenders. The 51¢ per gallon "blender's credit" is paid to those who blend ethanol with gasoline before selling it to gas stations. Although it's paid to blenders, this is a competitive business and the market prevents them from profiting from it. Instead, it is passed on to producers or consumers depending on the relative price of gasoline and ethanol. Since markets often play tricks on regulators, this is worth a closer look.

Suppose oil prices are high enough that ethanol and gasoline cost the same to produce; say that's $2.00 per gallon. Ethanol producers will take advantage of the fact that blenders want the 51¢ credit, so they will push the wholesale price of ethanol all the way to $2.51, at which point blenders will still see it as just as costly as gasoline in spite of the subsidy. The USDA notes that over the past 25 years, the ethanol producers did in fact push the price this high, in fact, they pushed it about 3¢ higher. The result is that producers have captured all of the subsidy paid to blenders. This was probably the intention, but notice that with gasoline costing just as much as ethanol, the producers don't need any subsidy--the subsidy simply provides them with windfall profits.

Now suppose the producers did need the full subsidy because ethanol actually cost $2.51 to produce. They would still charge $2.51 and the blenders would still get the 51¢ credit so the ethanol would, in effect, cost blenders $2.00 just as before. But this time, the benefit goes to the consumer. Without the subsidy, the consumer would have to pay $2.51 (plus a markup) for the ethanol, the full wholesale price. With the subsidy, the consumer only pays $2.00 (plus a markup), so the consumer gets the full benefit of the subsidy.

• If ethanol costs the same as gasoline, the subsidy is not needed, but it goes to producers as windfall profits.
  
• If ethanol costs more to produce than gasoline, and the full subsidy is needed, the ethanol subsidy goes to the consumet.

When ethanol costs more to produce than gasoline, but the consumer captures the blender's credit, the producers still do just fine. The demand for ethanol, partially the result of state requirements, will assure that the price ethanol producers are paid will be driven up to a level that covers their costs.