Pass-through of the policy-induced E85 subsidy: Insights from Hotelling's model

We build a structural model of imperfect competition for a retail market that supplies both low-ethanol (E10) and high-ethanol (E85) gasoline blends. The model permits us to study some impacts of the E85 subsidy induced by the U.S. Renewable Fuel Standard, specifically how the pass-through of this subsidy to retail prices is affected by market power. The model is rooted in Hotelling's horizontal differentiation framework, which is extended to also represent the imperfect substitutability between E10 and E85 (a vertical product differentiation attribute). The model naturally captures two sources of imperfect competition in the fuel market—refueling stations' market power arising from their spatial location, and limited availability of E85 stations. We derive both analytical and numerical solutions for Nash equilibrium outcomes under various scenarios. In our baseline parameterization, when the penetration of E85 stations is incomplete, we find that the pass-through rate is about 0.7. Complete penetration of E85 stations leads to near complete pass-through, notwithstanding the market power enjoyed by stations because of their spatial location. With monopolistic market power (e.g., collusion), however, with full penetration of E85 stations the pass-through rate is lower. Moreover, when market power only arises from location differentiation (duopoly model with full penetration of E85), the pass-through rate converges to one as the subsidy gets large, whereas it converges to zero if a station has exclusivity in selling E85 (partial penetration of E85) or there is collusion/monopoly power from collusion.