The Ferry Subsidy and the Island's Two Economies
A state government subsidises a ferry service linking a remote island (population 4,200) to the mainland, paying the operator $2.4 million a year so that fares stay at $18 return. Without the subsidy, the operator says fares would need to be $61 to break even, and patronage would fall from 210,000 return trips a year to an estimated 95,000. Island tourism operators report that 60% of visitors arrive by ferry and that a $61 fare would cut their bookings by roughly a third. The island's only supermarket estimates that 40% of its stock arrives via the ferry and that freight costs would rise by $9 per carton. The subsidy review committee notes that the ferry carries mostly island residents on 150,000 of the 210,000 trips, and that a competing private fast-cat service already runs twice daily at $55 return with 22,000 passengers a year.
1. Using the figures given, explain the likely incidence of removing the subsidy across three groups: island residents, tourism operators, and the supermarket. In your answer, distinguish between private costs and external costs where relevant.
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Residents bear the most direct cost: their fare rises from $18 to $61, a $43 increase per return trip. With 150,000 resident trips, that is roughly $6.45 million in additional annual private costs, dwarfing the $2.4 million the government saves. Because demand from residents is likely inelastic (commuting, medical trips, family visits), most of this falls on them rather than being avoided by cutting trips.
Tourism operators face an indirect cost. If a third of bookings are lost, their revenue falls, and the loss is a private cost to them but also a negative externality on the island's other businesses that depend on visitor spending. The fast-cat at $55 shows a substitute exists, but at 22,000 trips it cannot absorb 115,000 displaced passengers-so the substitute's capacity limits how much the market can adjust.
Supermarket shoppers absorb a freight cost increase of $9 per carton, which is passed through as higher shelf prices. For a small island market this is a private cost to consumers and a loss of consumer surplus.
Key judgement: the subsidy's removal saves $2.4 million publicly but shifts several million in costs onto residents and businesses, so the net social cost depends on whether the $2.4 million has a higher-valued alternative use. Recall of definitions alone cannot answer this; the numbers must be compared.
2. The committee proposes replacing the flat subsidy with a concession card giving residents a 50% fare discount while tourists pay full fare. Evaluate this proposal.
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Mechanics: residents pay $30.50 (half of $61), tourists pay $61. The government only funds the discount on resident trips. If resident trips stay near 150,000, the cost is roughly 150,000 × $30.50 ≈ $4.6 million-more than the current $2.4 million. So the proposal may not save money unless tourist numbers hold up at full fare.
Strengths: it targets assistance at those with the strongest equity claim (residents needing essential access) and uses price discrimination to capture more revenue from tourists, whose demand is more elastic and who have alternatives (the fast-cat). It preserves the externality benefit of visitor spending.
Weaknesses: the tourist market may collapse at $61 if the fast-cat and mainland alternatives draw them away, so the revenue assumption is fragile. Administering a concession card adds compliance costs. And a 50% discount still leaves residents paying $30.50 versus $18 today-a real welfare loss for low-income households.
Judgement: the proposal improves targeting but not necessarily cost. It is superior on equity grounds and inferior on fiscal grounds unless tourist demand proves inelastic. A tiered scheme (full concession for low-income residents, partial for others) would better balance the trade-off. The evaluation must weigh equity against efficiency and fiscal cost, not just restate the scheme.