#substitution effect

Economics Term of the Day: Substitution Effect

The reaction of a consumer’s demand for goods based on changes in relative prices holding purchasing power (or utility) constant (see Income Effect). We send out a new terms every morning during the workday. Be sure to click on the (Schedule Classes on Demand) tab above if you are interested in taking classes. The first one is free.

Accounting for the “substitution effect,” which describes the way more or less interchangeable commodities like palm and soybean oil tend to be swapped out for one another as buyers seek the lowest price, has proved to be a particularly challenging problem. The American biofuels law, for instance, was designed to support soybean and corn farmers, not palm-oil producers. But the United States began increasing foreign palm-oil imports nonetheless — they more than doubled by 2017 — in large part because so much of the domestic soybean production that once went to food was now being used for fuel. Much of that palm oil went to food production. But the increased use of palm oil in food production was largely a byproduct of the increased fuel-oil production. (In Europe, which also passed a biofuels mandate in 2009 and uses large amounts of palm-based biodiesel directly in its vehicles, the calculation was simpler.)

After the palm-oil companies gained control of the land, the clearing began. The fastest method was to rip out the forests with excavators and torch what remained. In 2015, the fires spread out of control. Kalimantan — and most of Indonesia, for that matter — was overwhelmed by billowing clouds of smoke and ash, visible from hundreds of miles away. NASA satellites detected more than 120,000 hot spots. As far away as Singapore and the Thai islands, people covered their faces with masks and prayed that their air conditioners could filter out the soot. 

Globally, peatlands from Norway to Brazil hold a volume of carbon equivalent to 21 percent of the entire carbon content in the earth’s soil. Indonesia’s peatlands alone (which are greater in size than others anywhere in the world except for those in Russia and Canada) now emit more than 500 megatons of CO₂ each year, an amount greater than the entire annual emissions of the state of California. Peatland forests hold 12 times as much carbon as other tropical rainforests around the world. This makes destroying them one of the planet’s greatest threats — and protecting them one of the most accessible opportunities to curb rising global emissions.

In perhaps the final turn of the life cycle, Indonesia is now working to become its own largest customer. In 2016, it instituted a 20 percent biofuels mandate for its domestic fuels, and this August, it extended that mandate to cover railways and power generation, too. Then it upped the pressure further, simply making it compulsory that Indonesians buy and use biodiesel. Officials offer a simple justification for this push: Under the Paris climate accord, they say, converting Indonesia to renewable fuels is the only way the country can meet its own climate goals.