1The Economics of Trade, Biofuel, and the Environment January 2008 Gal Hochman, Steven Sexton, and David Zilberman Abstract This work develops a general equilibrium framework to analyze changes in the energy sector within a global environment. It extends traditional trade models to consider issues of energy and the environment by introducing energy as a ubiquitous intermediate input in a general equilibrium trade model and by using a household model with energy entering directly into consumer decisions. This yields a framework to consider energy and climate change policy considerations. Recognizing the supply constraints on energy, the conditions which lead to the emergence of a biofuel sector, and the impact of these changes on prices, resource allocation and the pattern of trade are identified. Globalization and capital flow are shown to increase demand for energy, leading to a decline in food production and loss of environmental land. It is also shown that whereas neutral technical change in capital-intensive goods escalates tension between energy, food and the environment, neutral technical change in agricultural production, such as biotechnology and2second generation biofuel technologies, mitigates this pressure. 1. Introduction Energy is a commodity whose importance to the world community is second only to food. It is a ubiquitous factor in the production and consumption of most commodities, from heaters and hairdryers to cars and computers. Firms use energy to produce consumption goods, which consumers then combine with energy to generate utility, such as from transportation and heating. A conservative “back of the envelope” calculation attributes 22 percent of all U.S. energy consumption to households and 32 percent of all US (and 8 percent of all world) carbon emissions to individuals.1,2 This ubiquity necessitates a household production function model, which heretofore, has not been applied to energy. For most of the 20th century, non-renewable, non-recyclable petroleum has been the primary source of energy around the world. In response to the growing scarcity of fossil fuels and rising oil prices and motivated by concern over the environmental damage created by fossil fuel consumption, demand for renewable and clean energy is growing. In this context, biofuels have emerged as a promising new technology that can reduce dependency on traditional fossil fuel technology. Currently, biofuel is produced by the conversion of corn and sugar cane to ethanol or soy and palm oil to bio-diesel. It is hoped new technologies will be capable of converting cellulose crops, such as trees and grasses, into ethanol through processes that yield 1 The amount of energy consumed by autos, motorcycles and total energy use for transportation data are taken from Table 2.7 “Highway Transportation Energy Consumption by Mode” (Transortation Energy Data Book Edition 26-2007, Oak Ridge National Laboratory). The numbers are used to compute the fraction of total transportation energy consumed by residential users (approximately 55 percent). Total residential energy consumption is determined by summing residential sector consumption and 55 percent of transportation sector consumption according to Table 2.1a Energy Consumption by Sector: 1949-2006 (Annual Energy Review 2006, Energy Information Administration). Data were taken for the year 2001. Calculation of the fraction of residential transportation energy consumption excluded light vehicles, which include light trucks, SUVs and minivans. Therefore, this estimate is believed to provide a lower bound on the fraction of total energy consumed by residences.3greater net energy content. Today, biofuel is in its infancy and the bulk of the demand for biofuels is regulation-induced. Problems of adjustment from fossil fuel to biofuel slow adoption and create a role for policy. In this paper, we examine these local and global effects of the emerging paradigm-shift in energy. In addition to modeling energy as a ubiquitous good used by producers and consumers, we also model a renewable alternative that reduces some environmental externalities. The renewable technology is land intensive, and, therefore, introduces new environmental externalities. We show globalization and capital inflows lead to increased demand for energy. Assuming energy production from fossil fuel and biofuel, it is shown that greater demand for energy reduces land allocated to food production and yields higher food prices. While biofuel production yields environmental benefits by reducing build up of greenhouse gases, it also imposes environmental damage in the form of deforestation and biodiversity loss.3 Innovation can have significant effects on the environment, agriculture and energy, either strengthening the tension among the three or reducing it. Understanding these impacts, therefore, is important. For instance, technical change in the production of capital-intensive goods increases demand for energy, thereby reducing the allocation of land to food production and the environment. Also, although it is generally assumed agricultural biotechnology increases food production, we show that improvements in crop technology applied to biofuel crops may reduce land allocated for food. Improvements in food crop technology, however, unambiguously increase food production and alleviate the tension between food and energy. Formally, we assume a two-country model, with identical constant return to scale production technologies and identical homothetic preferences. Both countries are endowed with 2 Vandenbergh and Steinemann (2007). 1 Farrell, et al. (2006) estimate corn ethanol reduces greenhouse gas emissions “moderately” by 13 percent.4labor, land, and capital. Land is used for environmental preservation and can be converted to production at a cost. Energy can be produced using either capital and labor or land and labor, using fossil fuel or biofuel technology, respectively. To produce agricultural and capital products, labor, land, capital and energy are needed. The economic structure, therefore, builds on work (originated by Samuelson (1953), and extended by Melvin (1968), Drabicki and Takayama (1979), Dixit and Norman (1980), Deardroff (1980), Dixit and Woodland (1982), and many others) that attempts to apply the law of comparative advantage to more than two goods and more than two factors. It generalizes the results of two-by-two theory to many-goods