SUGGESTED SOLUTIONS FOR BUSINESS
CASE QUESTIONS FOR THOUGHT
This section offers suggested answers to the “Questions for Thought” that conclude each
business case at the end of chapters.
Part 1: What is Economics?
“How Priceline.com Revolutionized the
Travel Industry”
1. Explain how each of the twelve principles of economics
is illustrated in this case study.
Suggested Solution
1. Principle 1: People must make choices because resources
are scarce. Neither money nor time is unlimited; they are
both scarce resources. Priceline.com caters to customers
who have chosen to sacrifice some of their preferences
about convenience or quality in order to get a lower
price.
Principle 2: The opportunity cost of an item—what you
must give up in order to get it—is 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 bed—namely, the rev-
enue earned from a paying customer.
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.
Priceline.com was successful because its customers—
travelers, airlines, and hotels—were exploiting opportu-
nities to make themselves better off by using its services.
Priceline.com 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.com’s networks of hotels to find a
hotel rather than doing the research themselves. They
gain from using Priceline.com’s 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.com’s network rather than trying to
contact potential customers directly.
Principle 6: Because people respond to incentives, markets
move toward equilibrium. Expedia and Orbitz moved
into the online travel service industry in order to exploit
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opportunities that had been pioneered by Priceline.com.
In this way, the market for online travel services will move
toward equilibrium until there are no more opportunities
for new travel service companies to exploit.
Principle 7: Resources should be used efficiently to
achieve society’s goals. Priceline.com exploited an oppor-
tunity 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.
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 unoc-
cupied beds. Thus, introducing a market for those items—
which is what Priceline.com did—improves efficiency.
Principle 9: When markets don’t achieve efficiency, gov-
ernment intervention can improve society’s welfare. It
would have been inefficient to have major airlines fail
because of the public’s 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.
Principle 10: One person’s spending is another person’s
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 economy’s productive capacity. The overall econo-
my went into a slump after the attacks of September 2001
as the economy’s 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.
“Efficiency, Opportunity Cost,
and the Logic of Lean Production”
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 output—the output that worker
could have produced in the time spent wandering around.
2. Explain how lean manufacturing improves the economy’s
efficiency in allocation.
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 BCS-2 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
Suggested Solution
2. Lean production (also known as lean manufacturing)
improves the economy’s efficiency in allocation because,
for example, an automaker can more quickly switch to
producing more of the types of cars that more consum-
ers want and fewer of the types of cars that fewer con-
sumers want.
3. Before lean manufacturing innovations, Japan mostly
sold consumer electronics to the United States. How did
lean manufacturing innovations alter Japan’s compara-
tive advantage vis-à-vis the United States?
Suggested Solution
3. Before the innovations in lean production, Japan had a
comparative advantage vis-à-vis the United States in con-
sumer electronics. After the innovations, Japan’s com-
parative advantage vis-à-vis the United States shifted to
auto production.
4. Predict how the shift in the location of Toyota’s produc-
tion 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 Toyota’s 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-à-vis the United States.
Part 2: Supply and Demand
“An Uber Way to Get a Ride”
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 aren’t
enough?
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 market-
clearing 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.
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3. How does Uber’s surge pricing solve the problem
described in the previous question? Assess Kalanick’s
claim that the price is set to leave as few people possible
without a ride.
Suggested Solution
3. Uber’s 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
market equilibrium is achieved. Kalanick’s 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.
“Medallion Financial: Cruising Right
Along”
1. How does Medallion Financial benefit from the restric-
tion on the number of New York taxi medallions?
Suggested Solution
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 Financial 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 moti-
vation 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 Financial’s loans and the value
of its existing loans. So greater use of limousine ser-
vices hurts Medallion Financial. By offering limousine
services to their employees as a perk, companies are
in effect getting around the restriction on the number
of taxis in the city by creating their own, company-
specific taxi fleets.
3. Predict the effect on Medallion Financial’s 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 Financial’s 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.
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 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
There would be no need to take out a loan to buy one.
In addition, the value of Medallion Financial’s existing
loans would fall significantly.
“The Airline Industry: Fly Less,
Charge More”
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 inelas-
tic. We know this because airlines were able to increase
their revenues and profit by reducing supply and increas-
ing price.
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 incon-
venient times, but others are not.
Suggested Solution
2. By creating such variations in prices, the airline indus-
try 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 early-morning 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 aren’t 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 suit-
cases 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 substitu-
tions, like choosing a different airline that doesn’t
charge for such services.
4. Use an elasticity concept to explain under what condi-
tions the airline industry will be able to maintain its
high profitability in the future. Explain.
Suggested Solution
4. The airline industry will be able to maintain its profits
if price elasticity of supply is low—that is, if airlines
do not respond to an increase in travel demand by
greatly increasing quantity supplied. If price elasticity
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of supply is high, airlines will increase quantity sup-
plied dramatically when demand increases, prices will
fall, and their profits will fall as well.
Part 3: The Production Decision
“Kiva Systems’ Robots versus Humans:
The Challenge of Holiday Order
Fulfillment”
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 fired—in 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 sys-
tem 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. That’s 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 moder-
ate 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 rent-
ing robots when they need them, rather than purchasing
them and having them sit idle during much of the year.
“Shopping Apps, Showrooming, and
the Challenges Facing Brick-and-Mortar
Retailers”
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?
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 BCS-4 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
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 sev-
eral stores.
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 mar-
ket 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, retail-
ers 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 com-
parison shoppers.
Part 4: Beyond Perfect Competition
“Amazon and Hachette Go to War”
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 indus-
try, 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 edit-
ing, marketing, etc., but the ultimate source of produc-
tion is in the hands and minds of authors.
Now imagine a world in which every author’s style of
writing is the same. In such a world, nothing would dif-
ferentiate 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.
KrugESS4e_BCS.indd BCS-4
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 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 Amazon’s market power is its inves-
tors 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 publish-
ers 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 inves-
tors 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.
“Virgin Atlantic Blows the Whistle . . .
or Blows It?”
1. Explain why Virgin Atlantic and British Airlines might
collude in response to increased oil prices. Was the mar-
ket conducive to collusion or not?
Suggested Solution
1. They may have wanted to collude because it was rea-
sonable to fear that if one of them raised its price, the
other would not and so cause a price war. The market
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 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
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 actu-
ally 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.
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.
Part 5: Microeconomics and Public Policy
“Hunting Endangered Animals to Save
Them”
1. Using the concepts you learned about in the discussion
of public goods in Chapter 10, 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 person’s exploita-
tion 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. Hume’s ownership of a large ranch and the animals on
it means that he now has property rights on the com-
mon resource, leading him to efficiently maintain that
resource. A Kenyan rancher, who cannot own the wild-
life found on his or her land, cannot earn income from
the animals and so has an incentive to overuse the com-
mon 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 you learned about in the discussion of public
goods in Chapter 10.
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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.
“Welfare State Entrepreneurs”
1. Why does Norway have to have higher taxes overall
than the United States?
Suggested Solution
1. Norway provides health care to everyone, generous sup-
port 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 argu-
ments for social insurance in the text?
Suggested Solution
2. As we suggested, guaranteeing health care in the event
of illness can improve everyone’s 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 won’t 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.
Part 6: Introduction to Macroeconomics
“The Business Cycle and the Decline of
Montgomery Ward”
1. What caused the steep decline in department store sales
in the 1930s?
Suggested Solution
1. The steep decline in department store sales during the
1930s occurred as the U.S. economy went through the
Great Depression. There was a significant decline in con-
sumer spending during the Depression that then led to a
large drop in department store sales.
2. In terms of macroeconomics, what was the management
of Montgomery Ward betting would happen after World
War II?
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 BCS-6 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
Suggested Solution
2. After World War II, Montgomery Ward was betting on
stagnant growth and even a recession. If these events
occurred, they reasoned, consumers would be cau-
tious and spending would remain at or near the Great
Depression levels.
3. Economists believe that improvements in our macroeco-
nomic understanding over the course of the 1930s led to
better policies thereafter. If this is true, how did better
policies after World War II end up hurting Montgomery
Ward?
Suggested Solution
3. Better macroeconomic policies allowed the U.S. economy
to sustain longer business cycle expansions and mini-
mize the frequency, depth, and length of recessions. As
Montgomery Ward contracted their operations, consum-
er spending surged, allowing more competitors to enter
the department store industry.
“Getting a Jump on GDP”
1. Why do businesses care about GDP to such an extent
that they want early estimates?
Suggested Solution
1. Businesses care about GDP because it’s the prime indica-
tor of the overall state of the economy. Macroeconomics
tells us that the overall state of the economy matters a
lot to individual firms: what’s good or bad for the U.S.
economy as a whole is generally good or bad for each
individual company, too.
2. How do the methods of Macroeconomic Advisers and the
Institute for Supply Management fit into the three differ-
ent ways to calculate GDP?
Suggested Solution
2. Macroeconomic Advisers looks at purchases to estimate
GDP; in effect, it’s using the method of calculating GDP
that derives the total value of output by adding up total
spending on domestically produced goods and services.
The Institute for Supply Management, by contrast, surveys
producers to find out how much they’re producing; it is, in
a sense, using the method of calculating GDP that adds up
the value of production of final goods and services.
3. If private firms are producing GDP estimates, why do we
need the Bureau of Economic Analysis?
Suggested Solution
3. First, much of the data Macroeconomic Advisers uses
are provided by the U.S. government. Second, both
Macroeconomic Advisers and the Institute for Supply
Management have only partial data, relying on edu-
cated guesswork to fill in the blanks. Only the Bureau
of Economic Analysis has the scope and resources to
cover the whole field. The only way the private forecast-
ers know if they’ve gotten it right is by comparing their
results to the BEA data when they come in.
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“Day Labor in the Information Age”
1. Use the flows shown in Figure 14-7 to explain the role of
temporary staffing in the economy.
Suggested Solution
1. Figure 14-7 shows the flow of workers as they move from
employed to unemployed to not in the labor force. The
role of temporary staffing will increase the monthly flows
of workers going from unemployed to employed. Because
these jobs are temporary, we will also see an increase in
workers moving from employed to unemployed. Lastly, it
is also likely that the economy will experience an increase
in the number of workers moving back into the labor
force. Staffing companies make it easier to find a job,
albeit temporary, minimizing discouraged workers.
2. What is the likely effect of improved matching of job-
seekers and employers through online services listings
on the unemployment rate?
Suggested Solution
2. Unemployed workers are classified into three differ-
ent types of unemployment. A worker may be unem-
ployed for frictional, structural, or cyclical factors.
The improved matching of job-seekers and employers
through online services will increase the efficiency of
the job market, reducing the time it takes for someone to
find a job. The increased speed of job matching will help
reduce frictional unemployment. A reduction in fric-
tional unemployment will also reduce the natural rate of
unemployment in the long and short run.
3. What does the fact that temporary staffing fell sharply
during the 2008–2009 surge in unemployment suggest
about the nature of that surge?
Suggested Solution
3. As unemployment surged during the Great Recession,
employers were shedding both permanent and temporary
jobs. Temporary employment normally decreases dur-
ing a recession, but the decrease in 2008–2009 was far
greater than previous recessions. This suggests that the
rise in unemployment was cyclical in nature as opposed
to an increase in the natural rate.
Part 7: Economic Growth and
Fluctuations
“How Boeing Got Better”
1. A modern jet airliner does pretty much the same thing as
an airliner from the 1960s: it gets you there from here, in
about the same time. Where’s the technological progress?
Suggested Solution
1. The most notable technological progress is invisible to
the naked eye. Small but significant design improve-
ments, achieved with the help of new computing
technologies, have made aircraft more aerodynamic.
Fundamental changes in engine design and airframe
construction make planes much lighter, leading to
drastic improvements in fuel efficiency. Nearly half
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 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
the airframe for the Boeing 787 is comprised of new
composite materials, including carbon fiber reinforced
plastic, resulting in a 20% reduction in weight.
2. Do scientific advances play any role in the progress we’ve
described? Explain.
Suggested Solution
2. As discussed in the answer to the previous question,
scientific advances have allowed aircraft to become
more aerodynamic through the sophisticated use of new
computing technologies. Additionally, scientific advances
have led to the creation of carbon fiber materials that
allow airplanes to be significantly lighter when com-
pared to the old aluminum frames.
3. Some travelers complain that the flight experience has
gone downhill. Does this refute the claim of technologi-
cal progress?
Suggested Solution
3. Over the last fifty years, airline travel has become more
affordable. By utilizing newer technologies, airlines have
been able to pass along cost savings to passengers. A
decrease in the cost of air travel has resulted in many
more passengers flying today than in the past, when a
plane ticket cost more.
The common complaint of airline passengers about
cramped seating does not refute the claim of technologi-
cal progress. In fact, one could argue that it’s actually
another result of technological progress. Airlines have
spent years developing the smallest and lightest seats
possible that also offer durability and some degree of
comfort. Seat designers are even using carbon fiber and
titanium technologies to replace the heavy metal seat
frames of the past, allowing airlines to save even more
on fuel.
“Slow Steaming”
1. How did Maersk’s problem in 2011 relate to our analysis
of the causes of recessions?
Suggested Solution
1. In late 2010, Maersk faced sharply higher fuel prices,
a price spike that affected all other businesses and
consumers in the economy as well. In other words,
the economy experienced a negative supply shock: a
leftward shift of the short-run aggregate supply curve.
Other things equal, a negative supply shock increases
the aggregate price level and, in the short run, leads to a
decrease in aggregate output as the economy experiences
a recessionary gap. As the short-run aggregate supply
curve shifts leftward, aggregate output decreases as the
economy moves along the aggregate demand curve. A
negative supply shock such as this is one of the causes
of recessions.
2. The Fed had to make a choice between fighting two evils
in early 2008. How would that choice affect Maersk com-
pared with, say, a company producing a service without
expensive raw-material inputs, like health care?
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Suggested Solution
2. The two evils the Federal Reserve had to fight were an
increase in the aggregate price level as the short-run
aggregate supply curve shifted to the left and a decrease
in aggregate output as a recessionary gap developed.
Determining policy in the face of a supply shock is diffi-
cult. To fight an increase in the price level, the Fed could
have reduced aggregate demand—at the cost of further
reducing aggregate output. To fight the recessionary gap,
the Fed could have increased aggregate demand—at the
cost of further raising the aggregate price level.
The Fed chose to pursue a policy of increasing aggre-
gate demand, which—other things equal—results in a
further increase in the aggregate price level. A higher
price level, particularly higher prices for raw-material
inputs such as fuel, hits transport companies like Maersk
particularly hard. Although, eventually, all prices in the
economy rise after a negative supply shock, companies
that use more raw-material inputs, such as large ship-
ping companies, are more immediately affected than
companies, such as health care providers, that don’t rely
on those inputs. If the Fed had instead chosen to pursue
a policy of reducing aggregate demand, this would have
resulted in a decrease in fuel costs and a decrease in the
aggregate price level which would have benefited compa-
nies, like Maersk, that are more immediately affected by
raw-material prices. Of course, a decrease in aggregate
demand could also result in a drop in demand for ship-
ping services.
3. In 2011 the world economy was holding up fairly well,
but Europe was sliding back into recession. What do you
think was happening to the business of intra-European
transport (which mainly goes by truck, not ship)? Why?
Suggested Solution
3. The trucking industry in Europe, which also relies on
fuel, experienced a similar fate as the shipping indus-
try when fuel costs surged. But, unfortunately for the
trucking industry, it was also experiencing a decrease
in demand for its services. As Europe slid into a reces-
sion, aggregate demand shifted leftward as consumer
spending fell. The shipping industry, in contrast, was for-
tunate not to be hit by both rising fuel costs and falling
demand.
Part 8: Stabilization Policy
“Here Comes the Sun”
1. How did the political reaction to government funding for
the Solana project differ from the reaction to more con-
ventional government spending projects such as roads
and schools? What does the case tell us about how to
assess the value of a fiscal stimulus project?
Suggested Solution
1. Unlike roads and schools, the Solana project was con-
troversial because it meant that government funds were
paid to a non-American firm. It was also controversial
because the long-term viability of solar power depended
upon future government subsidies—again, unlike roads
and schools. However, the Solana case shows that the
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value of a fiscal stimulus project is a matter of whether
or not it creates jobs at the right time.
2. In the chapter we talked about the problem of lags in
discretionary fiscal policy. What does the Solana case
tell us about this issue?
Suggested Solution
2. Unfortunately, Solana is a good example of the prob-
lem of making discretionary fiscal policy react quickly.
It was a complicated project, which took time to put
together, and it didn’t open until 2013, more than four
years after the financial crisis. This wasn’t a big problem
in this case because recovery from the 2007–2009 reces-
sion was so slow, but the economy would have long since
recovered from an ordinary recession.
3. Is the depth of a recession a good or a bad time to under-
take an energy project? Why or why not?
Suggested Solution
3. Assuming that a solar plant was a good thing to build,
it was a very good idea to do it while many construction
workers had nothing else to do and borrowing was very
cheap.
“The Perfect Gift: Cash or a Gift Card”
1. Why are gift card owners willing to sell their cards for a
cash amount less than their face value?
Suggested Solution
1. A gift card is not as liquid as cash. Cash can be turned
into merchandise in any store; a gift card can be used
only at its issuer.
2. Why do gift cards for retailers like Walmart, Home
Depot, and Whole Foods sell for a smaller discount than
those for retailers like the Gap and Aeropostale?
Suggested Solution
2. Retailers like Walmart, Home Depot, and Whole Foods
sell necessities, but the Gap and Aeropostale sell non-
necessities. There will be a larger pool of potential
buyers for cards from retailers of necessities than
from sellers of non-necessities because more people
have constrained budgets and so are shopping only for
necessities. In addition, because people shop repeatedly
for necessities, they know they are more likely to use
up the face value of a card they can use for necessi-
ties than one usable only for non-necessities. So more
potential buyers compete to buy cards for necessities,
which drives their discount down compared to cards
for non-necessities.
3. Use your answer from Question 2 to explain why cash
never “sells” at a discount.
Suggested Solution
3. Cash can be used to purchase any good or service, neces-
sity or non-necessity; it is accepted everywhere. Also, it
comes in any face value you want. So there will always be
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an extremely large number of people willing to “buy cash”
because the price of a dollar will never be less than a dollar.
4. Explain why retailers prefer to reward loyal customers
with gift cards instead of rebate checks.
Suggested Solution
4. Most customers who receive a rebate check deposit the
check into their checking account, withdraw the cash,
and use it to pay for purchases. However, those purchases
need not be from the issuer of the rebate check. In con-
trast, a gift card must be used at the retailer that issues
it. Also, cash doesn’t expire, but gift cards often do. And
because a gift card has a predetermined face value, it is
more likely that a customer will not use it all up—unlike
cash, which is always eventually spent. For all these rea-
sons, a retailer can capture breakage on a gift card but
not on a rebate check. So retailers will prefer gift cards.
5. Recent legislation restricted retailers’ ability to impose
fees and expiration dates on their gift cards and
mandated greater disclosure of their terms. Why do
you think Congress enacted this legislation?
Suggested Solution
5. Retailers have an incentive to adopt policies that
increase breakage (the amount of a gift card that
accrues to the retailer rather than the cardholder),
such as imposing fees and expiration dates. Not telling
customers about these policies increases breakage. So
Congress has intervened to restrict these practices.
“PIMCO Bets on Cheap Money”
1. Why did PIMCO’s view that unemployment would stay
high and inflation low lead to a forecast that policy inter-
est rates would remain low for an extended period?
Suggested Solution
1. The Taylor rule suggests that the Fed sets interest rates
based on the unemployment rate and the inflation rate.
If unemployment stays high while inflation is low, this
would indicate that the Fed would keep policy rates
low—in fact, close to zero.
2. Why would low policy rates suggest low long-term
interest rates?
Suggested Solution
2. Long-term rates largely reflect expectations about future
short-term rates. If investors expect short-term rates to
stay low for a long time, this should lead to low long-
term rates now.
3. What might have caused long-term interest rates to rise
in late 2010, even though the federal funds rate was still
zero?
Suggested Solution
3. Even though the federal funds rate stayed near zero in
late 2010, investors expected it to rise eventually, once
the economy had recovered. Increased optimism meant
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 ANSWERS TO BUSINESS CASE QUESTIONS FOR THOUGHT
that investors moved up their expectation of when the
federal funds rate might rise, leading to a rise in long-
term rates.
Part 9: The International Economy
“Li & Fung: From Guangzhou to You”
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.
2. What principle do you think underlies Li & Fung’s deci-
sions on how to allocate production of a good’s inputs
and its final assembly among various countries?
Suggested Solution
2. Comparative advantage is the principle that underlies Li
& Fung’s 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
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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.
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
3. A retailer that purchased jeans directly from a manu-
facturer in mainland China would not benefit from the
gains from trade that arise from sourcing inputs from
different countries according to those countries’ com-
parative advantage.
4. What is the source of Li & Fung’s 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 & Fung’s 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.
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