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This section offers suggested answers to the Questions for Thought that conclude each
business case at the end of chapters.

Chapter 1
Suggested Solution

Principle 7: Resources should be used efficiently to

achieve societys goals. exploited an opportunity to use resources more efficiently. It is inefficient
to have empty hotel rooms and airline seats if someone is
willing to pay some price to use them on short notice.

1. Principle 1: People must make choices because resources

are scarce. Neither money nor time is unlimited; they are
both scarce resources. caters to customers
who have chosen to sacrifice some of their preferences
about convenience or quality in order to get a lower

Principle 8: Because people usually exploit gains from

trade, markets usually lead to efficiency. It is inefficient
to have planes flying with empty seats and hotels with
unoccupied beds. Thus, introducing a market for those
itemswhich is what didimproves

Principle 2: The opportunity cost of an itemwhat you

must give up in order to get itis its true cost. The true
cost of an empty airplane seat or an empty hotel bed is
the revenue the airline or hotel could have earned from
the next best use of that seat or bednamely, the revenue earned from a paying customer.

Principle 9: When markets dont achieve efficiency, government intervention can improve societys welfare. It
would have been inefficient to have major airlines fail
because of the publics temporary fear of flying. Vast
resources would have been wasted as pilots and support
staff lost their jobs, planes were mothballed, necessary
trips cancelled, and so on. It improved efficiency for the
government to step in and temporarily aid the airline
industry so that it could survive the temporary downturn.

1. Explain how each of the twelve principles of economics

is illustrated in this case study.

Principle 3: How much is a decision at the margin.

How much more a customer is willing to pay for a
ticket to a destination depends upon how much time
and inconvenience is saved by purchasing the higher
priced ticket.
Likewise, how much more a customer is willing to
pay for a ticket purchased well in advance of his travel
date depends upon how much more security he gains by
advance planning rather than waiting to purchase. The
same principle applies to decisions about the quality and
location of hotels, and so on.
Principle 4: People usually respond to incentives,
exploiting opportunities to make themselves better off. was successful because its customers
travelers, airlines, and hotelswere exploiting opportunities to make themselves better off by using its services. also responded to incentives to make itself
better off by expanding into new profitable markets
such as Europe.
Principle 5: There are gains from trade. Travelers gain
from using Priceline.coms networks of hotels to find a
hotel rather than doing the research themselves. They
gain from using Priceline.coms services to book a flight
rather than contacting each airline individually. Also,
travelers gain by using the services of airlines and hotels,
rather than transporting themselves or pitching a tent
overnight to sleep in. Hotels, particularly in Europe, gain
from using Priceline.coms network rather than trying to
contact potential customers directly.
Principle 6: Because people respond to incentives, markets
move towards equilibrium. Expedia and Orbitz moved
into the online travel service industry in order to exploit
opportunities that had been pioneered by
In this way, the market for online travel services will move
towards equilibrium until there are no more opportunities for new travel service companies to exploit.

Principle 10: One persons spending is another persons

income. In the aftermath of the attacks of September
2001, as people stopped spending on items like travel the
income of airline workers was severely reduced.
Principle 11: Overall spending sometimes gets out of line
with the economys productive capacity. The overall economy went into a slump after the attacks of September 2001
as the economys productive capacity exceeded its spending.
Principle 12: Government policies can change spending.
The $15 billion aid appropriation by Congress was spent
on stabilizing the airline industry and prevented major
airline failures.

Chapter 2
1. What is the opportunity cost associated with having a
worker wander across the factory floor from task to task
or in search of tools and parts?

Suggested Solution
1. The opportunity cost of a worker wandering across the
factory floor is forgone outputthe output that worker
could have produced in the time spent wandering around.
2. Explain how lean manufacturing improves the economys
efficiency in allocation.

Suggested Solution
2. Lean production (also known as lean manufacturing)
improves the economys efficiency in allocation because,
for example, an automaker can more quickly switch to
producing more of the types of cars that more consumers want and fewer of the types of cars that fewer consumers want.


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Answers to Business Case Questions for Thought

3. Before lean manufacturing innovations, Japan mostly

sold consumer electronics to the United States. How did
lean manufacturing innovations alter Japans comparative advantage vis--vis the United States?

Suggested Solution
3. Before the innovations in lean production, Japan had a
comparative advantage vis--vis the United States in consumer electronics. After the innovations, Japans comparative advantage vis--vis the United States shifted to
auto production.
4. Predict how the shift in the location of Toyotas production from Japan to the United States is likely to alter
the pattern of comparative advantage in automaking
between the two countries.

Suggested Solution
4. The shift in the location of Toyotas production from
Japan to the United States means that it is likely that
Japan will no longer have a clear comparative advantage
in automaking vis--vis the United States.

Chapter 3
1. Before Uber, how were prices set in the market for rides
in New York City? Was it a competitive market?

Suggested Solution
1. Before Uber, prices for rides were set by city regulators.
This was not a competitive market because the price was
not set by supply and demand but by city regulators.
2. What accounts for the fact that during good weather
there are typically enough taxis for everyone who
wants one, but during snowstorms there typically arent

Suggested Solution
2. If everyone who wants to get a taxi during good weather
can typically get one, then this implies that the price
set by regulators is approximately equal to the marketclearing price on good weather days. But a snowstorm
is likely to produce two changes to supply and demand:
an increase in demand (rightward shift of the demand
curve) because more people want to ride in a taxi rather
than walk or wait for a bus at any given price; and a
decrease in supply as more taxi drivers want to stay
warm and dry at home at any given price. As a result
of these two shifts, the market-clearing price rises. But
because the actual price is set by regulators and cannot
increase, a shortage of taxis arises.
3. How does Ubers surge pricing solve the problem
described in the previous question? Assess Kalanicks
claim that the price is set to leave as few people possible
without a ride.

Suggested Solution
3. Ubers surge pricing solves this problem because it
allows drivers to charge higher prices until supply equals
demand. This increases the quantity of rides supplied
while reducing the quantity of rides demanded until

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market equilibrium is achieved. Kalanicks claim is true.

At any price lower than the equilibrium price, there is
a shortage of taxis and fewer people actually get rides;
at any price higher than the equilibrium price there are
fewer customers, so fewer rides are transacted.

Chapter 4
1. Use the concepts of consumer surplus and producer surplus to analyze the exchange between The Boss and his
fans. Draw a diagram to illustrate.

Suggested Solution
1. By pricing tickets below the market equilibrium price,
fans that get tickets receive greater consumer surplus
than they would have received at the market equilibrium
price: the increased consumer surplus is a way for a
band to reward fans loyalty. Correspondingly, producer
surplus is lower than it would have been: the reduced
producer surplus is the money that bands forfeit when
they price tickets below the market equilibrium price.
In the accompanying diagram, the supply curve for
tickets is drawn as a vertical line: the supply of tickets
for any particular concert is fixed at the number of seats
available at the venue, here QE . The demand curve is
downward-sloping as lower ticket prices encourage more
fans to buy tickets. The market equilibrium is at point E,
with a market price of PE and a quantity bought and sold
of QE . Pricing tickets at a price PC that is below the market equilibrium price acts like a price ceiling: it creates a
shortage of tickets. Consumer surplus is the area below
the demand curve but above the price; in the diagram it
is given by the sum of areas X and Y. Producer surplus is
the area above the supply curve but below the price; it is
shown by area Z in the diagram.
Price of







Quantity of tickets

If tickets were priced at the market equilibrium price

PE , consumer surplus would be lower (area X), and producer surplus would be higher (the sum of areas Y and
Z). In other words, the amount of consumer surplus
given by area Y is Bruce Springsteens reward for his
fans loyalty; but it is also the money that he forfeits by
pricing tickets below the market equilibrium price.
2. Explain how the rise of the internet has disrupted this

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Suggested Solution
2. The rise of internet resellers like StubHub and
TicketsNow allows the ticket price paid by consumers
to rise; if we assume that all tickets are scooped up and
resold, then price rises to the market equilibrium price
PE . In this case, the resellers capture Y, the consumer
surplus that had formerly gone to fans.
3. Draw a diagram to show the effect of resellers on the
allocation of consumer surplus and producer surplus in
the market for concert tickets. What are the implications
of the internet for all such exchanges?

Suggested Solution
3. If all fans bought tickets from internet resellers, the
price of tickets would rise to the market equilibrium
price, PE . Look again at the diagram accompanying
solution 1. As the price rises from PC to PE, consumers
now receive consumer surplus equal to area X. However,
producer surplus rises to the sum of areas Y and Z, the
area above the supply curve but below the price. Of this
producer surplus, area Z goes to the band and area Y is
captured by the internet reseller. The result for Bruce
Springsteen is described by one of his lyrics: Your
own worst enemy has come to town. His fans are not
rewarded for their loyalty (they obtain tickets only at the
market equilibrium price, not the lower box office price),
and the resulting increase in producer surplus goes to
the internet reseller, not to The Boss.


in effect getting around the restriction on the number

of taxis in the city by creating their own, companyspecific taxi fleets.
3. Predict the effect on Medallion Financials business if New
York City eliminates restrictions on the number of taxis.
That is, if the quota is removed.

Suggested Solution
3. Eliminating restrictions on the number of taxis would
destroy Medallion Financials business. The quota rents
that accrue to the owners of medallions would fall to
zero, leading the value of a medallion to fall to zero.
There would be no need to take out a loan to buy one.
In addition, the value of Medallion Financials existing
loans would fall significantly.

Chapter 6
1. How would you describe the price elasticity of demand for
airline flights given the information in this case? Explain.

Suggested Solution
1. The price elasticity of demand for airline flights is inelastic. We know this because airlines were able to increase
their revenues and profit by reducing supply and increasing price.

1. How does Medallion Financial benefit from the restriction on the number of New York taxi medallions?

2. Using the concept of elasticity, explain why airlines

would create such great variations in the price of a ticket
depending on when it is purchased and the day and time
the flight departs. Assume that some people are willing
to spend time shopping for deals as well as fly at inconvenient times, but others are not.

Suggested Solution

Suggested Solution

Chapter 5

1. Medallion Financial benefits from the restriction

on the number of taxi medallions because demand
for its loans and the amount of interest it earns on
them increase as the price of medallions goes up.
In addition, its loans are secured by the medallions
purchased by its borrowers; as a result, those loans
are worth more when medallion prices are high. And
since the fewer the medallions, the higher their price,
Medallion Finance benefits from the restriction on the
number of medallions.
2. What will be the effect on Medallion Financial if New
York companies resume widespread use of limousine
services for their employees? What is the economic motivation that prompts companies to offer this perk to their
employees? (Note that it is very difficult and expensive to
own a personal car in New York City.)

Suggested Solution
2. If more New Yorkers are using limousine services
instead of taking taxis, the demand for taxis falls,
leading to a fall in income for taxi drivers and a fall
in the value of a medallion. This will reduce both the
demand for Medallion Financials loans and the value
of its existing loans. So greater use of limousine services hurts Medallion Financial. By offering limousine
services to their employees as a perk, companies are

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2. By creating such variations in prices, the airline industry

is trying to appeal to customers who have a high price
elasticity of demand as well as charge higher prices to
those with a low price elasticity of demand. Customers
with a high price elasticity of demand will shop for deals,
buy their tickets midweek, and fly on cheaper earlymorning flights. So by offering lower fares for tickets
purchased midweek or for flights that depart in the early
morning, airlines attract those customers with a high
price elasticity of demand. Customers with a low price
elasticity of demand arent willing to do those things, so
the airlines can and do charge them higher prices.
3. Using the concept of elasticity, explain why airlines have
imposed fees on things such as checked bags. Why might
they try to hide or disguise fees?

Suggested Solution
3. Because airlines know that travelers have a low price
elasticity of demand for services like having their suitcases fly with them or being served drinks onboard,
they know they can raise revenue by imposing fees on
these services. Airlines often try to hide or disguise
these fees to prevent travelers from making substitutions, like choosing a different airline that doesnt
charge for such services.

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4. Use an elasticity concept to explain under what conditions the airline industry will be able to maintain its
high profitability in the future. Explain.

2. What principle do you think underlies Li & Fungs decisions on how to allocate production of a goods inputs
and its final assembly among various countries?

Suggested Solution

Suggested Solution

4. The airline industry will be able to maintain its profits

if price elasticity of supply is lowthat is, if airlines
do not respond to an increase in travel demand by
greatly increasing quantity supplied. If price elasticity
of supply is high, airlines will increase quantity supplied dramatically when demand increases, prices will
fall, and their profits will fall as well.

2. Comparative advantage is the principle that underlies Li

& Fungs decisions. Inputs that require more skill or are
more capital-intensive can be produced in countries that
have relatively higher-skilled workers or are relatively
more abundant in capital, such as Hong Kong and Japan.
Similarly, inputs that are more labor-intensive can be
produced in countries that are relatively more abundant
in labor, like mainland China and Thailand.

Chapter 7
1. What effect do you think the difference in state sales tax
collection has on Amazons sales versus BarnesandNoble.
coms sales?

3. Why do you think a retailer prefers to have Li & Fung

arrange international production of its jeans rather than
purchase them directly from a jeans manufacturer in
mainland China?

Suggested Solution

Suggested Solution

1. It is easy to compare the price of books among the various

online retailers and choose the one with the lowest price.
As a result, consumers are more likely to buy from Amazon
than from because they will seek to
pay a lower final price by avoiding paying the sales tax.

3. A retailer that purchased jeans directly from a manufacturer in mainland China would not benefit from the
gains from trade that arise from sourcing inputs from
different countries according to those countries comparative advantage.

2. Suppose sales tax is collected on all online books sales.

From the evidence in this case, what do you think is the incidence of the tax between seller and buyer? What does this
imply about the elasticity of supply of books by book retailers? (Hint: Compare the pre-tax prices of the book.)

4. What is the source of Li & Fungs success? Is it based on

human capital, on ownership of a natural resource, or on
ownership of capital?

Suggested Solution

4. The source of Li & Fungs success is human capital.

The company understands how to use the principle of
comparative advantage to exploit gains from trade in the
production process. In addition, it is skilled in providing
quality control and logistics.

2. The fact that the pre-tax price is the same at Amazon

and means that all of the tax is
being borne by the consumer. In other words, the price
elasticity of books is perfectly elastic.
3. How did Amazons tax strategy distort its business
behavior? What measures would eliminate these

Suggested Solution

Chapter 9
1. Give an example of a type of rational decision making illustrated by this case and explain your choice.

Suggested Solution

Suggested Solution

3. To avoid collecting sales tax, Amazon refused to expand

its physical operations such as warehouses, distribution
centers, and even partnerships with affiliates in much of
the United States. This increased the time it took for customers to receive their merchandise and made Amazons
operations more costly. These distortions would be eliminated by making Amazon collect sales tax, regardless of
where the customer is located or where Amazons operations are.

1. J. C. Penney customers were using the anchoring behavioral strategy, which is a form of bounded rationality. They
looked to the pre-sale price as a benchmark to estimate the
value of the good and, therefore, the real savings they were
getting once the discount was applied.

Chapter 8
1. Why do you think it was profitable for Li & Fung to go
beyond brokering exports to becoming a supply chain manager, breaking down the production process and sourcing
the inputs from various suppliers across many countries?

Suggested Solution
1. By sourcing inputs from various suppliers across many
countries, Li & Fung was able to allocate production to
where it is most cost effective.

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2. Give an example of a type of irrational decision making

illustrated by this case and explain your choice.

Suggested Solution
2. J. C. Penney customers who followed the sales-and-coupon
strategy were underestimating their opportunity costs.
They werent actually paying less under the sales-andcoupon pricing strategy, yet they were expending a lot of
time and effort to keep track of sales and clip coupons
without any payoff.
3. What purpose does Walmarts price-match guarantee
serve? What do you predict would happen if it dropped this
policy? Would you predict its competitorssay, the local
supermarket or K-Martwould adopt the same policy?

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Suggested Solution
3. Walmarts price-match guarantee means that its customers
can be assured that Walmarts prices are indeed low and
therefore they do not need to search for an anchor to verify
this. As a result, the local supermarket or K-Mart would
lose their customers to Walmart if they didnt offer the
same guarantee. If Walmart dropped the price guarantee,
however, they would become like J. C. Penney and lose

Chapter 10
1. Give an example of a normal good and an inferior good
mentioned in this case. Cite examples of substitution
effects and income effects from the case.

Suggested Solution
1. A normal good is a good for which demand rises as income
rises; full-service restaurant meals are normal goods. An
inferior good is a good for which demand rises as income
falls; fast-food meals are inferior goods. Price discounts
and promotions at fast-food outlets have given rise to substitution effects: the substitution of cheaper fast-food meals
for more expensive full-service restaurant meals and the
substitution of discounted items on the menu for more
expensive items. Examples of negative income effects in
response to reduced consumer income are fewer purchases
of full-service restaurant and fast-food meals and the preparation of more meals at home. One can also argue that
there is a positive income effect on consumers purchasing power: the discounted price menus at fast-food outlets
allow consumers to purchase more meals than they would
have been able to, other things equal.
2. To induce fast-food customers to eat more healthful
meals, what alternatives are there to bans? Do you think
these alternatives would work? Why or why not?

Suggested Solution
2. One could tax less healthful items more heavily and also
try to educate consumers to choose the more healthful
items. The tax is likely to work because it would induce
a substitution effect away from the now more expensive
unhealthful items to the now less expensive healthful ones.
Advertising is less likely to work because people appear
to have strong preferences for unhealthful foods. In other
words, consumers are often not rational in their choices.
3. What do you think accounts for McDonalds success?
Relate this to concepts discussed in the chapter.

Suggested Solution
3. It is likely that McDonalds is more successful than its rivals
because it has aggressively expanded both its menu and its
advertising. By giving customers more choice, the company
can appeal to a wider range of customers, especially those
who formerly ate in full-service restaurants. It understands
that different people have different preferences. McDonalds
has also exploited the income effect: spending-constrained
consumers can purchase their espresso drinks for less at
McDonalds than at coffeehouses like Starbucks.

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Chapter 11
1. Assume that a firm can sell a robot, but that the sale
takes time and the firm is likely to get less than what it
paid. Other things equal, which system, human-based or
robotic, will have a higher fixed cost? Which will have a
higher variable cost? Explain.

Suggested Solution
1. Other things equal, a robotic system will have a higher
fixed cost because unlike humans, robots cannot be
hired and firedin other words, purchased and sold
quickly and cheaply. Since a robotic system reduces the
need for humans, a human-based system will have more
workers than a robotic system. So a human-based system will have a higher variable cost.
2. Predict the pattern of off-holiday sales versus holiday
sales that would induce a retailer to keep a human-based
system. Predict the pattern that would induce a retailer
to move to a robotic system.

Suggested Solution
2. A retailer that has a huge surge in holiday sales is likely
to maintain a human-based system. Thats because it
would have to install a large number of robots to handle
its holiday sales that would then sit idle during the rest
of the year. In contrast, a retailer that has only a moderate increase in holiday sales is likely to move to a robotic
system because it will have a relatively small number of
robots left idle during the off-season.
3. How would a robot-for-hire program affect your
answer to Question 2? Explain.

Suggested Solution
3. A robot-for-hire program would make retailers with
a large ratio of holiday sales to off-holidays sales more
likely to switch to a robotic system. These retailers could
acquire a robotic system at a much lower cost by renting robots when they need them, rather than purchasing
them and having them sit idle during much of the year.

Chapter 12
1. From the evidence in the case, what can you infer about
whether or not the retail market for electronics satisfied
the conditions for perfect competition before the advent
of mobile-device comparison shopping? What was the
most important impediment to competition?

Suggested Solution
1. The retail market for electronics did not satisfy the
conditions for perfect competition because stores like
Best Buy were able to charge higher prices than other
retailers. In perfect competition every transaction at
the market equilibrium takes place at the same price.
The major impediment to competition was customers
inability to compare prices across various retailers,
which would have required them to go to or call several stores.

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2. What effect is the introduction of mobile shopping apps

having on competition in the retail market for electronics?

On the profitability of brick-and-mortar retailers like Best
Buy? What, on average, will be the effect on the consumer
surplus of purchasers of these items?

Suggested Solution
2. The introduction of these apps will make the retail market for electronics much more competitive, which will
reduce the profitability of brick-and-mortar retailers
like Best Buy. The consumer surplus of purchasers will
increase because, on average, they now pay a lower price.
3. Why are some retailers responding by having manufac-

turers make exclusive versions of products for them? Is

this trend likely to increase or diminish?

Suggested Solution
3. By carrying products exclusive to their shelves, retailers can foil mobile-device comparison shoppers because
no other store will have the same product. This trend is
likely to increase for two reasons: (1) It is a way to avoid
the commodification of the items that retailers sell.
Because these items differ across retailers, there is no
way to do a direct price comparison. (2) More and more
people are likely to join the ranks of mobile-device comparison shoppers.

Chapter 13
1. What is the source of surplus in this industry? Who
generates it? How is it divided among the various agents
(author, publisher, and retailer)?

Suggested Solution
1. To understand the source of the surplus in this industry, note that the production is the writing of books by
authors. Surplus is created by trade between authors
who write books and readers who enjoy reading them.
Publishers may improve the product by providing editing, marketing, etc., but the ultimate source of production is in the hands and minds of authors.
Now imagine a world in which every authors style of
writing is the same. In such a world, nothing would differentiate a thriller written by Ms. Dagger versus one
written by Mr. Cloak. Books would be like commodities, making the book industry perfectly competitive.
The equilibrium price of books would settle at a level
that leaves authors indifferent between writing a book
or not. In this world, all of the surplus accrues to readers. Note that readers, who value variety, education,
and quality in their books, may not enjoy this world
very much.
But the real world does not operate this way. Authors
do indeed write in different ways. Successful authors
write well enough that their books command a price
that allows them to capture some of the market surplus (and like Douglas Preston, to live a comfortable
lifestyle). Moreover, efforts by publishers in the form of
editing, advertising, etc., can increase the share of the
surplus going to the author by raising readers willingness to pay for a given book. Total surplus is higher

KrugWellsEC4e_Micro_BCS.indd 6

here than in the fictional world in which all the books

are the same because readers derive more enjoyment
from the higher quality of books that successful
writers produce, as shown by their willingness to pay
higher prices.
The share of the surplus captured from readers is then
split between the author, the publisher (if there is one),
and the retailer.
2. What are the various sources of market power here?
What is at risk for the various parties?

Suggested Solution
2. Successful authors produce a unique product that is
protected by copyright laws. Hence they hold some
market power that allows them to command higher
prices for their books compared to lower quality, more
commodity-like books. Amazon has some market power
deriving from their control of a significant share of the
retail capacity in the book market. This has allowed
it to capture an increasing share of the surplus that
accrues to authors and their publishers. Amazon has
acquired this capacity through its immensely costly
investments in its website and its delivery system. The
ultimate source of Amazons market power is its investors who have bankrolled these investments on the
promise of future profits.
As Amazon attempts to capture a larger share of the
market surplus, successful authors and their publishers are at risk of losing surplus to Amazon. Moreover,
if publishers are at risk of being forced out of business,
successful authors fear that a source of their success
will disappear.
Amazon is at risk of losing the backing of these investors who are growing impatient with the many years of
losses. If investors desert it and Amazon loses its ability
to subsidize its expensive investments, then it could lose
its dominance in the retail industry.

Chapter 14
1. Explain why Virgin Atlantic and British Airlines might
collude in response to increased oil prices. Was the market conducive to collusion or not?

Suggested Solution
1. They may have wanted to collude because it was reasonable to fear that if one of them raised its price, the other
would not and so cause a price war. The market was conducive to collusion because so much of it was dominated
by British Airways, making it a natural price leader.
2. How would you determine whether illegal behavior actually occurred? What might explain these events other
than illegal behavior?

Suggested Solution
2. For the airlines actions to have been illegal, it would
have been necessary for the two companies to make an
agreement to coordinate price increases. If one imposed
the surcharge and the other merely followed suit, their
actions would not have been illegal.

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3. Explain the dilemma facing the two airlines as well as

their individual executives.

Suggested Solution
3. Both the airlines and their individual executives faced
a prisoners dilemma because the first to confess would
gain immunity. As the defense lawyer said, it was best to
confess even if there had been no illegal activity in order
to protect oneself. Moreover, it was in the interest of
British Airways, once accused, to cut a deal for leniency
and to sacrifice its accused executives.

Chapter 15
1. What explains the complexity of todays razors and the
pace of innovation in their features?

Suggested Solution
1. The complexity of razors and pace of innovation in their
features are a reflection of the intense non-price competition between Schick and Gillette.
2. Why is the razor business so profitable? What explains
the size of the advertising budgets of Schick and Gillette?

Suggested Solution
2. The business is so profitable because Schick and Gillette
have been able to convince customers to pay higher
prices for more complex razors. Schick and Gillette have
large advertising budgets to accomplish this.
3. What explains the popularity of the Dollar Shave Club?
What dilemma do Schick and Gillette face in their decisions about whether to maintain their older, simpler
razor models? What does this indicate about the welfare
value of the innovation in razors?

Suggested Solution
3. The popularity of the Dollar Shave Club can be explained
by its lower prices. For customers who find that upgraded features are not worth the cost (those who are welfare reducing), DSC offers an appealing alternative. The
dilemma that Schick and Gillette face in maintaining
their older, simpler models is that these cheaper models
can cannibalize sales of the newer, more complex ones.
But if Schick and Gillette dont maintain these models, a
competitor could, and very well might, undercut them.

Chapter 16
1. Describe the nature of the externality in social media

Suggested Solution
1. Social media sites work as a network externality because
they are channels for communication among their users.
2. Assume that there are two competing social media
websites. Explain why it is likely that one will come to
dominate. Explain why the decline of a site is likely to be
swift, with a cascade of departures.

KrugWellsEC4e_Micro_BCS.indd 7


Suggested Solution
2. Whenever there is a network externality there is a positive feedback effect: the more other people join the site,
the more I will want to join the site. If two sites are of
equal size, then over time it is very likely that events will
tip in favor of one site over anotherevents such as technical problems or too much advertising. Once the decline
of a site begins, it will be rapid as the positive feedback
works in reverse: the more other people leave a site, the
more I will want to leave the site.
3. Explain the nature of the problem that undermined
MySpace relative to Facebook. Is it unique to MySpace
or common to all social media sites?

Suggested Solution
3. MySpace was undermined by its imperative to make
money at a time when Facebook was not focused on
profit. Recall that in network externalities the attractiveness of a network is increased the lower the cost of
using it. So irritating ads, along with a slow and buggy
platform, increased the cost to MySpace users of using it
compared to using Facebook. However, this phenomenon
is not unique to MySpace. Facebook has been trying to
use its site to make money and, as could be predicted,
has alienated many of its users.

Chapter 17
1. Using the concepts you learned in this chapter, explain
the economic incentives behind the huge losses in
Kenyan wildlife.

Suggested Solution
1. Unprotected African wildlife and their grazing areas are
a common resource. It is difficult to stop people from
exploiting them by poaching the animals or turning the
land to agricultural use, but any one persons exploitation means fewer animals and less grazing area for
them. Without some economic incentive to conserve the
wildlife and their grazing lands, Kenyans will overuse
them, leading to huge losses.
2. Compare the economic incentives facing John Hume
with those facing a Kenyan rancher.

Suggested Solution
2. Humes ownership of a large ranch and the animals on
it means that he now has property rights on the common resource, leading him to efficiently maintain that
resource. A Kenyan rancher, who cannot own the wildlife found on his or her land, cannot earn income from
the animals and so has an incentive to overuse the common resource: killing the wildlife and turning grazing
areas into income-producing farmland.
3. What regulations should be imposed on a rancher who
sells opportunities to trophy hunt? Relate these to the
concepts in the chapter.

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Answers to Business Case Questions for Thought

Suggested Solution
3. Regulations should ensure that the rancher, like John
Hume, is committed to the long-term care of the
ranch and its animals. Regulations should establish
economic incentives so that the rancher regards the
common resource as an asset and protects its value
over time.

Chapter 18
1. Why does Norway have to have higher taxes overall
than the United States?

Suggested Solution
1. Norway provides health care to everyone, generous support for the unemployed, financial assistance to the poor,
and so on; all this costs money, so the large welfare state
requires correspondingly high taxes.
2. This case suggests that government-paid health care
helps entrepreneurs. How does this relate to the arguments for social insurance in the text?

Suggested Solution
2. As we suggested, guaranteeing health care in the event
of illness can improve everyones expected welfare, since
everyone knows that he or she might have significant
medical expenses at some point. Similarly, potential
entrepreneurs know that their venture might fail; their
expected welfare when starting a business is higher if
they know they wont lose health coverage even if their
enterprise fails.
3. How would the incentives of people like Wiggo Dalmo
be affected if Norwegian health care was means-tested
instead of available to all?

Suggested Solution
3. If Norwegian health coverage was means-tested, it
would act as an effective tax on success: Wiggo Dalmo
would have lost his coverage once his business expanded
and he began making a lot of money.

Chapter 19

2. How does the Costco story fit into our discussion of the
reasons similar workers may end up being paid different

Suggested Solution
2. Costco and Walmart compete for workers. By paying an
above market wage, an efficiency wage, Costco is inducing its workers to be more productive and it is aiming to
reduce turnover. Because Costco workers stay in their
jobs longer, they can acquire job skills and experience
and, as a result, have a higher value of marginal product.
Therefore, a Costco employee will be paid more than a
Walmart employee.
3. President Obama, as his speech indicated, would like to
encourage more companies to adopt a high-wage strategy. Other politicians would like to do the same. What are
the possible positive and negative effects if this becomes
official government policy?

Suggested Solution
3. If government policy encourages more companies to act
like Costco, paying higher wages to induce workers to
be more productive, the gains would be direct: higher
earnings for many workers, with many of the beneficiaries being workers who would otherwise have been
poorly paid. Also, to the extent that the strategy works,
the economy as a whole would become more productive
and richer. There are two possible downsides. First, what
apparently works for Costco might not work for everyone, so costs would riseand this cost increase would
be passed on in the form of higher prices. Second, companies could end up hiring fewer workers in total, raising the natural rate of unemployment and hurting those
workers who are shut out.

Chapter 20
1. Did AIG accurately assess the default risk that it
insured? Why or why not?

Suggested Solution
1. AIG did not accurately assess the default risk it insured
because its losses far exceeded the premium income it
had earned.

1. Use the marginal productivity theory of income distribution to explain how companies like Walmart can pay
workers so little that they fall below the poverty line.

2. What did AIG assume about the probabilities of defaults

by different homeowners in the U.S. housing market?
Were they wrong or right?

Suggested Solution

Suggested Solution

1. The marginal productivity theory of income distribution

is consistent with a low wageone that falls below the
poverty rateif workers have a low value of marginal
product. This can happen if the job requires very little
skill, education, or job experience. Walmart has designed
its business so that this is the case. For example,
Walmart touts its low prices but not its customer service.
As a consequence of paying low wages, Walmart has
high worker turnover. And high worker turnover means
that the average Walmart worker has a low value of marginal product because she has not acquired job skills or

2. AIG assumed that defaults by different homeowners in

the U.S. housing market were independent events. It was
very clearly wrong since the collapse of the U.S. housing
market showed that defaults were positively correlated.

KrugWellsEC4e_Micro_BCS.indd 8

3. What are the examples of moral hazard in the case? For

each example, explain who committed the moral hazard
and against whom and identify the source of the private

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Answers to Business Case Questions for Thought

Suggested Solution
3. There are several examples of moral hazard in the case:
a. By preventing AIGs auditors from inspecting the
divisions books, Cassano committed moral hazard
against AIG. He had private information about the
extent of the risk to which he had exposed AIG.
b. Goldman Sachs and other investment banks that
insured bonds they knew were likely to default committed moral hazard against AIG. They had private
information about the quality of the bonds for which
they purchased CDS insurance.


4. Cite an example of adverse selection from the case. What

was the source of the private information?

Suggested Solution
4. AIG faced adverse selection in insuring mortgage-backed
securities because some investors, like Goldman Sachs,
had private information about the likelihood of the
default of their bonds.

c. AIG committed moral hazard against its insurees by

placing its Financial Products Division in London,
outside the reach of U.S. regulations. It (or, more
accurately, Cassano) had private information about
AIGs insufficient capital for the risks it was undertaking. This was moral hazard against its insurees
because in the event of loss, AIG would not have
enough capital to pay their claims.

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