Yes, Will Ferrell did eat cotton balls in Elf. This scene occurs when Buddy the Elf is in the middle of a press conference and someone asks him a question about what it's like to work with Santa. Buddy then proceeds to eat cotton balls in front of the crowd as a way to demonstrate his dedication to Santa and his job. He then says "The point is, I don't think it's a stretch to say that I'm Santa's favorite toy maker. But you'll have to forgive me if I don't elaborate on that. I don't want to get into any more trouble than I already have."