3.2.3. Market Demand

There are three stylized facts in the production market of the fuel ethanol industry in China. First, fuel ethanol is a typical emerging product whose market demand is gradually forming and expanding or shrinking. Second, there is a competition between fuel ethanol and liquid fossil fuels. The market demand for fuel ethanol comes from the substitution of the market demand for fossil fuels. Third, the governmen<sup>t</sup> can intervene in the fuel ethanol market through legal or administrative measurements.

In the production market, fuel ethanol is directly incorporated into the formal gasoline sales network, which is an oligopoly market. This means that the price of fuel ethanol will be consistent with gasoline prices, which are decided by the supplier as follows:

$$p\_t^b = (1 + \rho\_1)p\_t^f \tag{8}$$

where *pb t* denotes the price of fuel ethanol, *pf t* denotes the price of gasoline, and ρ1 denotes the markup percentage.

In pilot provinces, the demand for fuel ethanol will reach a larger scale in the short term after the implementation of the pilot because the pilot consumers can only purchase E10 gasoline. On the other hand, the output of fuel ethanol is relatively smaller in the early stages of the fuel ethanol industry. This means that market demand is horizontal before reaching a specific value but becomes vertical after reaching a specific value. Therefore, Equation (8) can be regarded as the demand function of the fuel ethanol market.

Then, we need to consider the entry, adjustment, or exit of the consumer. As mentioned above, the evolution of the fuel ethanol market is reflected in the entry of potential consumers and the adjustment of consumption by incumbent consumers or the exit from the market.

*Consumer Entry Rules:* As the consumption of E10 is mandatory, new consumers of fuel ethanol will enter into the market with the expansion of pilot areas.

*Consumer Adjustment Rules:* When the price of fuel ethanol remains constant, the changes in demand only a ffected by the changes in consumer's fuel spending. Therefore, consumers will increase or decrease their demand for fuel ethanol based on changes in total fuel spending. The adjustment to fuel ethanol purchases for specific consumers is

$$
\dot{\alpha}^{b}\_{j,t} = \dot{M}\_{j,t} \tag{9}
$$

where . *x b j*,*t* denotes the percent change in fuel ethanol demand for consumer *j* in period *t*; . *Mj*,*<sup>t</sup>* denotes the percent change in consumer *j's* income in period *t.*

*Consumer Exit Rules:* Consumers who are not satisfied with the consumption of fuel ethanol will choose to exit the market.
