Question

The Energy Policy Act of 2005 and the Energy Independence and Security Act of 2007 mandated enormous increases in ethanol consumption in the US. Most ethanol in the US is made from corn. Assuming that corn production takes place in a perfectly competitive market, explain what would happen to the price of corn in the global market as a result of these two laws? Use economic theory to explain what would happen to the number of corn farmers and production of corn in the long run in this market. Also, what should happen to prices in the long run? Explain your analysis using graphs and a few sentences.

Answer 1

Pace 1 D QuantityCarn O

The initial equilibrium in the corn market occurs at point E1 where market demand and market supply curve intersects. The above two laws will increase the demand for corn in the corn market and thus shift the demand curve for corn rightwards to D'D' and new short run equilibrium occurs at point E2 where price level has risen to OP2 and quantity of corn has increased to OQ2. This increase in the price of corn will make it profitable for corn farmers and producers to produce corn and they will be earning supernormal profits. This will attract the entry of new firms in the market in the long and thus the supply curve of corn will shift rightwards to S'S' until prices fall to the initial price level at OP1 and thus new long run equilibrium occurs at point E3 where prices have fallen to OP1 and quantity of corn produced and sold has increased to OQ3.