Biofuel subsidies: an open-economy analysis

We present a general equilibrium analysis of biofuel subsidies in an open-economy context. In the small-country case, when a Pigouvian tax on conventional fuels such as crude is in place, the optimal biofuel subsidy is zero. When the tax on crude is not available as a policy option, however, a second-best biofuel subsidy (or tax) is optimal. In the large-country case, the optimal tax on crude departs from its standard Pigouvian level and a biofuel subsidy is optimal. A biofuel subsidy spurs global demand for food and confers a terms-of-trade benefit to the food-exporting nation. This might encourage the food-exporting nation to use a subsidy even if it raises global crude use. The food importer has no such incentive for subsidization. Terms-of-trade effects wash out between trading nations; hence, any policy intervention by the two trading nations that raises crude use must be jointly suboptimal.