Is Arbitrage Tying the Price of Ethanol to that of Gasoline? Evidence from the Uptake of Flexible-Fuel Technology

Brazil is the only sizable economy to date to have developed a home-grown ubiquitously-retailed alternative to fossil fuels in road transportation: ethanol from sugar cane. Perhaps unsurprisingly, the uptake of flexible-fuel vehicles (FFVs) has been tremendous. Five years after their introduction, FFVs accounted for over 90% of new car sales and 30% of the car stock. We provide a stylized model of the sugar/ethanol industry which incorporates substitution by consumers, across ethanol and gasoline at the pump, and substitution by producers, across domestic regional and export markets for ethanol and sugar. We argue that the model stands up well to the empirical co-movement in prices at the pump in a panel of Brazilian states. The paper offers a case study of how agricultural and energy markets link up at the very micro level.