ChainWhat it assumes · how to break it
Start
The government pays bus operators a subsidy for each passenger journey, to keep fares down on local services.
1
As a result, operators' costs of providing each journey fall, so the supply curve shifts down vertically by the subsidy.
subsidy · supply
subsidy · supply
Assumes: The subsidy is paid per unit.
But: A lump-sum grant does not lower the cost of each extra journey, so it need not shift supply or lower fares.
2
This means the fare falls, but by less than the subsidy, because part of it raises the price operators receive.
subsidy incidence
subsidy incidence
Assumes: Operators compete on price.
But: A single operator running a route may keep much of the subsidy as profit unless fares are regulated.
3
Since demand is less price elastic than supply, most of the subsidy is passed on to passengers as lower fares.
PED · PES · incidence
PED · PES · incidence
Best link to attack
Assumes: Demand is less elastic than supply.
Assumes: Demand is less elastic than supply.
But: If operators have few spare buses and drivers, supply is inelastic and more of the subsidy stays with them as a higher price received.
4
Consequently, passengers pay lower fares, travel more and gain consumer surplus.
consumer surplus
consumer surplus
Assumes: Price is what holds back bus use.
But: Passengers who care more about frequency and reliability gain little if the subsidy only lowers fares on a poor service.
End
Consumers pay a lower price, buy more and gain consumer surplus.
Evaluation chain
- E1However, the gain to consumers depends on how the subsidy is split between a lower price paid and a higher price received.
- E2If supply is inelastic, for example because operators cannot add buses and drivers quickly,
- E3then operators cannot expand services much, so fares fall only a little and much of the subsidy raises the price they receive.
- E4So consumers gain most when supply is elastic; in the short run a large part of the subsidy may go to producers instead.
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Questions this answers
- Explain, using a diagram, how a subsidy affects consumer surplus.
- Assess the impact of a subsidy for bus travel on consumers.
- Analyse why the benefit of a subsidy to consumers depends on elasticity.
Diagram
Supply shifts down vertically by the subsidy. The price consumers pay falls from P1 to P2 and the price producers receive rises to P2 plus the subsidy. Shade the consumer gain: the area between P1 and P2 to the left of the demand curve.
Reverse and related
Removing the subsidy → supply shifts up, fares rise and passengers travel less and lose surplus.