D Graphics Worth: Krugman Economics 3e in ModsPrinciple 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
unoccupied 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.
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 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.
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.
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.
Chapter 1
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 towards equilibrium. Expedia and Orbitz moved
into the online travel service industry in order to exploit
opportunities that had been pioneered by Priceline.com.
In this way, the market for online travel services will move
towards equilibrium until there are no more opportuni-
ties for new travel service companies to exploit.
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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.
Chapter 4
1. Use the concepts of consumer surplus and producer sur-
plus 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 P C that is below the mar-
ket 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
tickets
Quantity of tickets
E
X
Y
Z D
S
BA
Price
ceiling
Q E
PE
PC
Shortage
If tickets were priced at the market equilibrium price
PE , consumer surplus would be lower (area X), and pro-
ducer 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 Springsteen’s 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
exchange.
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.
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 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.
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
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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.
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.
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 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 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 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.
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.
Chapter 5
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 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 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
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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
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.
Chapter 9
1. Give an example of a type of rational decision making illus-
trated by this case and explain your choice.
Suggested Solution
1. J. C. Penney customers were using the anchoring behav-
ioral 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.
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 weren’t actually paying less under the sales-and-
coupon 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 Walmart’s price-match guarantee
serve? What do you predict would happen if it dropped this
policy? Would you predict its competitors—say, the local
supermarket or K-Mart—would adopt the same policy?
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
of supply is high, airlines will increase quantity sup-
plied dramatically when demand increases, prices will
fall, and their profits will fall as well.
Chapter 7
1. What effect do you think the difference in state sales tax
collection has on Amazon’s sales versus BarnesandNoble.
com’s sales?
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 BarnesandNoble.com because they will seek to
pay a lower final price by avoiding paying the sales tax.
2. Suppose sales tax is collected on all online books sales.
From the evidence in this case, what do you think is the inci-
dence of the tax between seller and buyer? What does this
imply about the elasticity of supply of books by book retail-
ers? (Hint: Compare the pre-tax prices of the book.)
Suggested Solution
2. The fact that the pre-tax price is the same at Amazon
and BarnesandNoble.com 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 Amazon’s tax strategy distort its business
behavior? What measures would eliminate these
distortions?
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 cus-
tomers to receive their merchandise and made Amazon’s
operations more costly. These distortions would be elimi-
nated by making Amazon collect sales tax, regardless of
where the customer is located or where Amazon’s opera-
tions are.
Chapter 8
1. Why do you think it was profitable for Li & Fung to go
beyond brokering exports to becoming a supply chain man-
ager, 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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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 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.
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 sev-
eral stores.
Suggested Solution
3. Walmart’s price-match guarantee means that its customers
can be assured that Walmart’s 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 didn’t offer the
same guarantee. If Walmart dropped the price guarantee,
however, they would become like J. C. Penney and lose
customers.
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 sub-
stitution 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 prep-
aration of more meals at home. One can also argue that
there is a positive income effect on consumers’ purchas-
ing 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 McDonald’s success?
Relate this to concepts discussed in the chapter.
Suggested Solution
3. It is likely that McDonald’s 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. McDonald’s
has also exploited the income effect: spending-constrained
consumers can purchase their espresso drinks for less at
McDonald’s than at coffeehouses like Starbucks.
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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.
Chapter 14
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 reason-
able to fear that if one of them raised its price, the other
would not and so cause a price war. The market was con-
ducive 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.
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.
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 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 commodi-
ties, 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 read-
ers. 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 sur-
plus (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’ willing-
ness to pay for a given book. Total surplus is higher
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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 today’s 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 compe-
tition 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 deci-
sions 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 upgrad-
ed features are not worth the cost (those who are wel-
fare 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 don’t maintain these models, a
competitor could, and very well might, undercut them.
Chapter 16
1. Describe the nature of the externality in social media
websites.
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.
Suggested Solution
2. Whenever there is a network externality there is a posi-
tive 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 another—events such as tech-
nical 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 attrac-
tiveness 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 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 in the chapter.
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2. How does the Costco story fit into our discussion of the
reasons similar workers may end up being paid different
wages?
Suggested Solution
2. Costco and Walmart compete for workers. By paying an
above market wage, an efficiency wage, Costco is induc-
ing 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 strate-
gy. 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 benefi-
ciaries 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 every-
one, so costs would rise—and this cost increase would
be passed on in the form of higher prices. Second, com-
panies could end up hiring fewer workers in total, rais-
ing 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.
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
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.
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
information.
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 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.
Chapter 19
1. Use the marginal productivity theory of income distri-
bution to explain how companies like Walmart can pay
workers so little that they fall below the poverty line.
Suggested Solution
1. The marginal productivity theory of income distribution
is consistent with a low wage—one that falls below the
poverty rate—if 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 mar-
ginal product because she has not acquired job skills or
experience.
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Suggested Solution
3. There are several examples of moral hazard in the case:
a. By preventing AIG’s auditors from inspecting the
division’s 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 com-
mitted moral hazard against AIG. They had private
information about the quality of the bonds for which
they purchased CDS insurance.
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
AIG’s insufficient capital for the risks it was under-
taking. This was moral hazard against its insurees
because in the event of loss, AIG would not have
enough capital to pay their claims.
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.
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Solution
1. In each of the following situations, identify which of the twelve principles is at work.
a. You choose to shop at the local discount store rather than paying a higher price
for the same merchandise at the local department store.
b. On your spring break trip, your budget is limited to $35 a day.
c. The student union provides a website on which departing students can sell items
such as used books, appliances, and furniture rather than giving them away to
their roommates as they formerly did.
d. After a hurricane did extensive damage to homes on the island of St. Crispin,
homeowners wanted to purchase many more building materials and hire many
more workers than were available on the island. As a result, prices for goods and
services rose dramatically across the board.
e. You buy a used textbook from your roommate. Your roommate uses the money to
buy songs from iTunes.
f. You decide how many cups of coffee to have when studying the night before an
exam by considering how much more work you can do by having another cup ver-
sus how jittery it will make you feel.
g. There is limited lab space available to do the project required in Chemistry 101.
The lab supervisor assigns lab time to each student based on when that student is
able to come.
h. You realize that you can graduate a semester early by forgoing a semester of study
abroad.
i. At the student union, there is a bulletin board on which people advertise used
items for sale, such as bicycles. Once you have adjusted for differences in quality,
all the bikes sell for about the same price.
j. You are better at performing lab experiments, and your lab partner is better at
writing lab reports. So the two of you agree that you will do all the experiments,
and she will write up all the reports.
k. State governments mandate that it is illegal to drive without passing a driving exam.
l. Your parents’ after- tax income has increased because of a tax cut passed by
Congress. They therefore increase your allowance, which you spend on a spring
break vacation.
1. a. People usually exploit opportunities to make themselves better off. In this case,
you make yourself better off by buying merchandise at a lower price.
b. Resources are scarce. Since you have only $35 a day, your resources are limited
(scarce).
c. Markets usually lead to efficiency. The market here is represented by the buyers
and sellers who use the student union website to trade goods, in contrast to the
“nonmarket” of simply giving items away to one’s roommate. The market is effi-
cient because it enables people who want to sell items to find those who want to
buy those items. This is in contrast to a system in which items are simply left with
a roommate, who may have little or no desire to have them.
S-1
1
CHAPTER
First Principles
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Solution
d. Overall spending sometimes gets out of line with the economy’s productive capac-
ity. The spending by St. Crispin homeowners on building materials and workers
fell short of the economy’s ability to produce those goods and services. As a result,
prices on the island rose across the board (inflation).
e. One person’s spending is another person’s income. Your spending on the used
textbook is your roommate’s income.
f. “How much” is a decision at the margin. Your decision is one of “how much”
coffee to consume, and you evaluate the trade- off between keeping yourself awake
and becoming more jittery from one more cup of coffee.
g. Resources should be used as efficiently as possible to achieve society’s goals.
Allocating scarce lab space according to when each student can use that space is
efficient.
h. The real cost of something is what you must give up to get it. The real cost of a
semester abroad is giving up the opportunity to graduate early.
i. Markets move toward equilibrium. Any bicycle a buyer chooses will leave him or
her equally well off. That is, a buyer who chooses a particular bicycle cannot change
actions and find another bicycle that makes him or her better off. Also, no seller
can take a different action that makes him or her better off: no seller can charge a
higher price for a bicycle of similar quality, since no one would buy that bicycle.
j. There are gains from trade. If each person specializes in what he or she is good at
(that is, in comparison with others that person has an advantage in producing
that good), then there will be gains from specialization and trade.
k. When markets don’t achieve efficiency, government intervention can improve
society’s welfare. Unsafe drivers don’t take into account the dangers they pose to
others and often to themselves. So when unsafe drivers are allowed to drive, every-
one is made worse off. Government intervention improves society’s welfare by
assuring a minimum level of competence in driving.
l. Government policies can change spending. In this case, a tax cut has increased
spending.
2. Describe some of the opportunity costs when you decide to do the following.
a. Attend college instead of taking a job
b. Watch a movie instead of studying for an exam
c. Ride the bus instead of driving your car
2. a. One of the opportunity costs of going to college is not being able to take a job.
By choosing to go to college, you give up the income you would have earned on
the job and the valuable on- the - job experience you would have acquired. Another
opportunity cost of going to college is the cost of tuition, books, supplies, and so
on. Alternatively, the benefit of going to college is being able to find a better, more
highly paid job after graduation in addition to the joy of learning.
b. Watching the movie gives you a certain benefit, but allocating your time (a scarce
resource) to watching the movie also involves the opportunity cost of not being
able to study for the exam. As a result, you will likely get a lower grade on the
exam—and all that that implies.
c. Riding the bus gets you where you need to go more cheaply than, but probably not
as conveniently as, driving your car. That is, some of the opportunity costs of
taking the bus involve waiting for the bus, having to walk from the bus stop to
where you need to go rather than parking right outside the building, and probably
a slower journey. If the opportunity cost of your time is high (your time is
valuable), these costs may be prohibitive.
S-2 C H A P T E R 1 F I R S T P R I N C I P L E S
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C H A P T E R 1 F I R S T P R I N C I P L E S S-3
Solution
3. Liza needs to buy a textbook for the next economics class. The price at the college
bookstore is $65. One online site offers it for $55 and another site, for $57. All
prices include sales tax. The accompanying table indicates the typical shipping and
handling charges for the textbook ordered online.
a. What is the opportunity cost of buying online instead of at the bookstore? Note
that if you buy the book online, you must wait to get it.
b. Show the relevant choices for this student. What determines which of these
options the student will choose?
3. a. The opportunity cost of buying online is whatever you must give up to get the
book online. So the opportunity cost of buying online is the sum of the shipping
charges plus the opportunity cost of your time spent waiting for the book to arrive
(at the bookstore the book is available immediately) minus the cost saving you
receive by buying online versus buying at the bookstore.
b. Below is a list of all of Liza’s options and their purely monetary costs:
Buy from bookstore $65
Buy from first site (price $55), 1-day delivery $55 + $13.98 = $68.98
Buy from first site (price $55), 2-day delivery $55 + $08.98 = $63.98
Buy from first site (price $55), 3- to 7-day delivery $55 + $03.99 = $58.99
Buy from second site (price $57), 1-day delivery $57 + $13.98 = $70.98
Buy from second site (price $57), 2-day delivery $57 + $08.98 = $65.98
Buy from second site (price $57), 3- to 7-day delivery $57 + $03.99 = $60.99
It is clear that Liza would never buy from the second site, where the book costs
$57: for each delivery time, she is better off buying the book from the first site,
where the book costs $55. It is also clear that she would never buy the book from
the first site and have it delivered the next business day: it costs more that way
($68.98) than getting it from the bookstore (assuming that it is costless to get to
and from the bookstore). But it is not clear whether she will buy the book from
the bookstore or the first site with delivery times of 2 or 3–7 days: this depends on
her opportunity cost of time. The higher the cost of waiting, the more likely she is
to buy the book from the bookstore, where she does not need to wait.
4. Use the concept of opportunity cost to explain the following.
a. More people choose to get graduate degrees when the job market is poor.
b. More people choose to do their own home repairs when the economy is slow and
hourly wages are down.
c. There are more parks in suburban than in urban areas.
d. Convenience stores, which have higher prices than supermarkets, cater to busy
people.
e. Fewer students enroll in classes that meet before 10:00 A. M .
Shipping Delivery
method time Charge
Standard shipping 3–7 days $3.99
Second-day air 2 business days 8.98
Next-day air 1 business day 13.98
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Solution
Solution4. a. The worse the job market, the lower the opportunity cost of getting a graduate
degree. One of the opportunity costs of going to graduate school is not being able
to work. But if the job market is bad, the salary you can expect to earn is low or
you might be unemployed—so the opportunity cost of going to school is also low.
b. When the economy is slow, the opportunity cost of people’s time is also lower: the
wages they could earn by working longer hours are lower than when the economy
is booming. As a result, the opportunity cost of spending time doing your own
repairs is lower—so more people will decide to do their own repairs.
c. The opportunity cost of parkland is lower in suburban areas. The price per square
foot of land is much higher in urban than in suburban areas. By creating park-
land, you therefore give up the opportunity to make much more money in cities
than in the suburbs.
d. The opportunity cost of time is higher for busy people. Driving long distances to
supermarkets takes time that could be spent doing other things. Therefore, busy
people are more likely to use a nearby convenience store.
e. Before 10:00 A .M . the opportunity cost of time for many students is very high—it
means giving up an extra hour’s sleep. That extra hour is much more valuable
before 10:00 A .M . than later in the day.
5. In the following examples, state how you would use the principle of marginal analy-
sis to make a decision.
a. Deciding how many days to wait before doing your laundry
b. Deciding how much library research to do before writing your term paper
c. Deciding how many bags of chips to eat
d. Deciding how many lectures of a class to skip
5. a. Each day that you wait to do your laundry imposes a cost: you have fewer clean
clothes to choose from. But each day that you wait also confers a benefit: you can
spend your time doing other things. You will wait another day to do your laundry
if the benefit of waiting to do the laundry that day is greater than the cost.
b. The more research you do, the better your paper will be. But there is also an
opportunity cost: every additional hour you spend doing research means you can-
not do other things. You will weigh the opportunity cost of doing one more hour
of research against the benefit gained (in terms of an improved paper) from doing
research. You will do one more hour of research if the benefit of that hour out-
weighs the cost.
c. Each bag of chips you eat gives you a benefit: it satisfies your hunger. But it also
has a cost: the money spent for each bag (and, if you are weight- conscious, the
additional calories). You will weigh the cost against the benefit of eating one more
bag. If the cost is less than the benefit, you will eat that one more bag of chips.
d. Each lecture that you skip implies a cost: getting further behind with the material
and having to teach it to yourself just before the exam. But each skipped lecture
also means you can spend the time doing other things. You will continue to skip
lectures if the cost of skipping is lower than the benefit of spending that time
doing other things.
6. This morning you made the following individual choices: you bought a bagel and
coffee at the local café, you drove to school in your car during rush hour, and you
typed your roommate’s term paper because you are a fast typist—in return for which
she will do your laundry for a month. For each of these actions, describe how your
individual choices interacted with the individual choices made by others. Were other
people left better off or worse off by your choices in each case?
S-4 C H A P T E R 1 F I R S T P R I N C I P L E S
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C H A P T E R 1 F I R S T P R I N C I P L E S S-5
Solution
Solution
Solution6. When you bought the bagel and coffee, you paid a price for them. You would not
have bought that breakfast if your enjoyment of it (your welfare) had not been great-
er than the price you paid. Similarly, the café owner would not have sold you the
bagel and coffee if the price he received from you were less than the cost to him of
making them. This is an example of how everybody gains from trade: both you and
the café owner are better off.
When you chose to drive your car during the rush hour, you added to the congestion
on the road. Your choice had a side effect for other motorists: your driving slowed
everybody else down just a little bit more. Your choice made other motorists worse off.
Typing your roommate’s term paper in exchange for her doing your laundry is anoth-
er example of the gains that come from trade. Both of you voluntarily agreed to
specialize in a task that each is comparatively better at because you expected to gain
from this interaction. Your choice made both you and your roommate better off.
7. The Hatfield family lives on the east side of the Hatatoochie River, and the McCoy
family lives on the west side. Each family’s diet consists of fried chicken and corn-
on- the - cob, and each is self- sufficient, raising their own chickens and growing their
own corn. Explain the conditions under which each of the following would be true.
a. The two families are made better off when the Hatfields specialize in raising chick-
ens, the McCoys specialize in growing corn, and the two families trade.
b. The two families are made better off when the McCoys specialize in raising chick-
ens, the Hatfields specialize in growing corn, and the two families trade.
7. a. Gains from trade usually arise from specialization. If the Hatfields (compared
to the McCoys) are better at raising chickens and the McCoys (compared to the
Hatfields) are better at growing corn, then there will be gains from specialization
and trade.
b. Similar to the answer to part a, if the McCoys (compared to the Hatfields) are
better at raising chickens and the Hatfields (compared to the McCoys) are better
at growing corn, then there will be gains from specialization and trade.
8. Which of the following situations describes an equilibrium? Which does not? If the
situation does not describe an equilibrium, what would an equilibrium look like?
a. Many people regularly commute from the suburbs to downtown Pleasantville. Due
to traffic congestion, the trip takes 30 minutes when you travel by highway but
only 15 minutes when you go by side streets.
b. At the intersection of Main and Broadway are two gas stations. One station
charges $3.00 per gallon for regular gas and the other charges $2.85 per gallon.
Customers can get service immediately at the first station but must wait in a long
line at the second.
c. Every student enrolled in Economics 101 must also attend a weekly tutorial. This year
there are two sections offered: section A and section B, which meet at the same time
in adjoining classrooms and are taught by equally competent instructors. Section A is
overcrowded, with people sitting on the floor and often unable to see what is written
on the board at the front of the room. Section B has many empty seats.
8. a. This is not an equilibrium. Assume that all people care about is the travel time to
work (not, for instance, how many turns they need to make or what the scenery
is like). Some people could be better off using the side streets, which would cut
down their travel time. Eventually, as the situation moves to equilibrium (that is,
as more people use the side streets), travel times on the highway and along the
side streets will equalize.
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Solution
b. This might be an equilibrium. Those who buy gas at the first station would be
worse off by buying gas at the second if the value of their time spent waiting
exceeded the savings at the pump: they would save 15 cents per gallon but would
incur the opportunity cost of waiting in a long line. You should expect very busy
people (a high opportunity cost of time) to buy gas at the first station. Those
who buy gas at the second station might be worse off by buying gas at the first:
they would not have to wait in line but would pay 15 cents more per gallon. You
should expect people with a lot of free time (a low opportunity cost of time) to
buy gas at the second station.
c. This is not an equilibrium. If students from section A attended section B instead,
they would be better off: they could get seats and see the board without incurring
any cost (since the section meets at the same time and is taught by an equally
competent instructor). Over time, you should expect students to switch from
section A to section B until equilibrium is established.
9. In each of the following cases, explain whether you think the situation is efficient or
not. If it is not efficient, why not? What actions would make the situation efficient?
a. Electricity is included in the rent at your dorm. Some residents in your dorm leave
lights, computers, and appliances on when they are not in their rooms.
b. Although they cost the same amount to prepare, the cafeteria in your dorm con-
sistently provides too many dishes that diners don’t like, such as tofu casserole,
and too few dishes that diners do like, such as roast turkey with dressing.
c. The enrollment for a particular course exceeds the spaces available. Some students
who need to take this course to complete their major are unable to get a space
even though others who are taking it as an elective do get a space.
9. a. This is not efficient. If the lights were turned off, some students could be made
better off without making other students worse off because the college would save
money on electricity that it could spend on student programs. By leaving lights
and appliances on when leaving their rooms, residents do not take into account
the negative side effect they impose on their college—the higher cost of electricity.
If students were forced to pay their own individual electricity costs (that is, if they
fully took into account the cost of their actions), then they would turn the lights
and appliances off when leaving their rooms. This situation would be efficient.
b. This is not efficient. Instead of serving dishes that many diners do not like, the caf-
eteria should serve more of the equal-cost dishes that diners do like. That way, some
students could be made better off without other students being made worse off.
c. This is not efficient. In an efficient scheme, spaces would be allocated to those
students who value them most. In this case, however, some spaces are allocated
to students who value them less (those who take the course as an elective) than
other students (those who need the course to graduate). Efficiency could be
improved as follows: if a student who is not currently enrolled in the course val-
ues it more than a student who is enrolled, then the unenrolled student should be
willing to pay the enrolled student to give up his or her space. At some price, this
trade would make both students better off and the outcome would be efficient.
10. Discuss the efficiency and equity implications of each of the following policies. How
would you go about balancing the concerns of equity and efficiency in these areas?
a. The government pays the full tuition for every college student to study whatever
subject he or she wishes.
b. When people lose their jobs, the government provides unemployment benefits
until they find new ones.
S-6 C H A P T E R 1 F I R S T P R I N C I P L E S
KrugWellsECPS4e_Micro_CH01.indd S-6KrugWellsECPS4e_Micro_CH01.indd S-6 9/23/14 9:35 AM9/23/14 9:35 AM

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