This paper analyzes the effects of government subsidies and the Renewable Fuel Standard (RFS) on the U.S. ethanol industry. The authors first develop a stylized theory model of subsidies in which they examine which types of subsidies are more cost-effective for inducing investment in firm capacity, and how the presence of a mandate affects the relative cost-effectiveness of different types of subsidies. The authors then empirically analyze how government subsidies and the Renewable Fuel Standard affect ethanol production, investment, entry, and exit by estimating a structural econometric model of a dynamic game that enables us to recover the entire cost structure of the industry, including the distributions of investment costs, entry costs, and exit scrap values. The authors use the estimated parameters to evaluate three different types of subsidy: a production subsidy, an investment subsidy, and an entry subsidy, each with and without the RFS. While conventional wisdom and some of the previous literature favor production subsidies over investment subsidies, and while historically the federal government has used production subsidies to support ethanol, our results show that, for the ethanol industry, investment subsidies and entry subsidies are more cost-effective than production subsidies for inducing investment that otherwise would not have occurred.
