ChainWhat it assumes · how to break it
Start
The government subsidises bus journeys, whose use creates external benefits by reducing car traffic, congestion and emissions.
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 fares fall and passengers make more journeys, moving output from the free-market level towards the social optimum where MSB equals MSC.
social optimum · MSB
social optimum · MSB
Assumes: Demand responds to the lower fare.
But: Many drivers choose cars for convenience and journey time, so a lower bus fare attracts few of them.
3
As a result, some car journeys are replaced by bus journeys, reducing congestion and emissions, the external benefits that the free market ignored.
positive externality · external benefit
positive externality · external benefit
Best link to attack
Assumes: The new passengers would otherwise have driven.
Assumes: The new passengers would otherwise have driven.
But: Many extra journeys come from people who would have walked, cycled or not travelled, so congestion and emissions fall little.
4
Therefore, the welfare loss from underconsumption shrinks, and disappears if the subsidy equals the marginal external benefit at the social optimum.
welfare loss · marginal external benefit
welfare loss · marginal external benefit
Assumes: The subsidy matches the external benefit.
But: External benefits such as less congestion are hard to value in money, so the subsidy may be set at the wrong level.
End
Output rises towards the social optimum and the welfare loss from underconsumption falls.
Evaluation chain
- E1However, the external benefit depends on who the extra passengers are.
- E2If most extra journeys are made by people who would otherwise walk, cycle or stay at home,
- E3then few car journeys are removed and congestion and emissions barely change.
- E4So the subsidy raises bus use but reduces the welfare loss only to the extent that it draws drivers out of cars.
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Questions this answers
- Explain, using a diagram, how a subsidy can correct a positive externality.
- Assess whether subsidising public transport is the best way to reduce congestion.
- Evaluate the use of subsidies to correct market failure.
Diagram
MPB with MSB above it, and supply (MPC = MSC). The free market produces Q1 where MPB = MPC, below Q* where MSB = MSC; the welfare loss triangle lies between Q1 and Q*. The subsidy shifts supply down; if it equals the marginal external benefit at Q*, output reaches Q*.
Reverse and related
Removing the subsidy → fares rise, output falls back below the social optimum and the welfare loss returns.