Derivied Demand and Ethanol

Derived demand is a term used in the factor market used to explain that the demand for a resource such as labor is "derived" from the product demand. For example, suppose that consumers suddenly want more apps for their mobile devices. Businesses will now hire more programmers to make apps. In other words, the demand for programmers is directly related to the demand for the product that programmers make--apps. When the price of a product increases, the product becomes more valuable and the firm produces more. In order to produce more output, the firm has to hire more labor, use more land and capital. If the programmers become more proficient in production, then the firm can produce more output.

Theory suggests that the firm will hire more programmers. An excellent review of derived demand can be found here. In early 2000, the state of Iowa required Ethanol blending in gasoline. Lawmakers wanted to reduce dependence on foreign oil. As I remember the law, each year required a greater amount of Ethanol blending. To induce producers to grow corn for Ethanol, farmers were given a $0.51 subsidy. As a result, there was an increase in the price of corn through a change in demand, and an increase in the amount of land devoted to corn. As one Lake-View Auburn farmer told me, "There's only been two times in my life where I've seen corn prices increase and corn production increase at the same time."

What the 83-year old farmer meant was that an increase in the production of corn would mean an increase in supply that would decrease the price of corn. So all of the activity in the corn market had to be the result of government legislation. The legislation worked. Corn was being intensively grown and production techniques that required the use of pesticides increased productivity. Crops were not being rotated so that less wheat and soybeans were planted. Soil erosion and genetically modified foods became a world issue. The result was an increase in demand for the factor that produced corn. This is an example of derived demand.

Ethanol is produced in Midwest states and sold in Iowa, Illinois, Wisconsin, Minnesota, and Nebraska.  There may be other states, but I know Ethanol is not sold nation wide because it's too costly to transport.  Likewise, if the price of crude oil drops, Ethanol is more expensive so consumers will switch to another octane to save money.  Since Ethanol only helps consumers and producers in the Midwest, one must question the distributive, income, and ethical effects of the subsidy.  Like any law, the effects have unintended consequences such as unjustly enriching the Midwest.

One could make the argument that foods prices that use corn increased.  Some argue that the price of tortillas increased in Latin America so much that famine forced starving kids in Haiti to each dirt.

A fundamental concept in economics is that choices have a cost.  The Ethanol subsidy provided many benefits but also contained many costs.  Economist Jeremy Bentham believed that an action was moral if that action created the most good for the most people.  Clearly, the Ethanol subsidy violates that belief.  In fact, Bentham would argue for the removal of the subsidies.  That argument would fall on deaf "ears."