Entry of Alternative Fuels in a Volatile U.S. Gasoline Market

Dramatic increases in levels and volatility of gasoline prices observed in recent years may create market incentives for adoption of alternative fuels characterized by lower price volatility. This hypothesis is investigated by applying the real-options pricing approach to develop optimal thresholds for switching from conventional gasoline to alternative fuels such as ethanol blends. The main result of the paper is that given the historical price patterns of conventional gasoline and ethanol, switching to ethanol blends is an economically sound decision provided this does not decrease efficiency of the vehicle. Analysis of data subsamples during the periods of higher volatility of gasoline prices (Gulf War and War on Terrorism) provides even stronger support for this result.