Does Government’s Biofuel Incentive Payment Program Work in the Presence of Asymmetric Information?

Since combustion of fossil fuels can release a large amount of greenhouse gases into the atmosphere thereby accelerate the rate of climate change, biofuel from biomass has been suggested as a fuel of the future. We argue that if biofuel is to become a fuel of the future, the principal (government or social planner) should make monetary incentive payments to farmers willing to dedicate their farm land to growing bioenergy crops. The problem arises when the principal does not have information on whether these biofuel farmers are actually low-cost types or high-cost types. The idea of a biofuel incentive payment program is to distribute more incentive payments to high-cost farmers so as to induce them to participate in the program. Principal-agent model is used to study the effect of hidden information on the government’s incentive payments to biofuel farmers. Results show that with complete information both low-cost and high-cost type farmers have incentives to produce biofuel crops under the government contract. When information asymmetry is considered, low-cost farmers earn extra payments, but their optimal productivity level remains unchanged. In this second-best outcome with asymmetric information, high-cost farmers’ optimal level of productivity and incentive payments that they received depend on the marginal costs of raising tax revenue. Generally, our results suggest that the government’s biofuel incentive payment program may not be an effective tool in inducing biofuel crop production if asymmetric information is present and marginal costs of raising tax revenue are high.