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 government pays the subsidy on every unit sold, including journeys that would have been made anyway.
cost of a subsidy
cost of a subsidy
Assumes: The subsidy is paid on all units.
But: A targeted subsidy, for example only for young people or new routes, avoids paying for journeys that would happen anyway.
3
Since the lower price raises the quantity bought, the total cost rises with every extra unit, and rises most when demand and supply are price elastic.
PED · PES
PED · PES
Best link to attack
Assumes: Quantity responds strongly to the subsidy.
Assumes: Quantity responds strongly to the subsidy.
But: If demand is price inelastic, few extra journeys are made, so the cost rises little but most of the spending simply lowers fares for existing passengers.
4
Therefore, the government must raise taxes, borrow more or cut other spending, which is the opportunity cost of the subsidy.
opportunity cost · budget deficit
opportunity cost · budget deficit
Assumes: The subsidy is funded by extra spending.
But: If the subsidy reduces other public costs, such as road maintenance or treating illness caused by pollution, part of the cost is recovered.
End
Government spending rises by the subsidy per unit times the new quantity, with an opportunity cost elsewhere.
Evaluation chain
- E1However, the cost of the subsidy depends on how far quantity rises when the price falls.
- E2If demand and supply are price elastic, the subsidy brings a large rise in the number of journeys.
- E3As a result, the government pays the subsidy on many more units, so the bill grows well beyond the first estimate.
- E4So a subsidy is cheap only when quantity responds little, but then it also does little to correct the market failure.
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Questions this answers
- Explain how the cost of a subsidy to the government is calculated.
- Assess the costs of subsidising public transport.
- Discuss whether subsidies are good value for money for the government.
Diagram
Supply shifts down by the subsidy. The total cost to the government is the rectangle between the price producers receive and the price consumers pay, multiplied by the new quantity.
Reverse and related
Removing the subsidy → government spending falls, freeing funds for other uses.