Suggested Solutions for Business Case Questions for Thought This section offers suggested answers to the Questions for Thought at the end of each chapter’s Business Case. CHAPTER 1 1. Explain how each of the twelve principles of economics is illustrated in this case. 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 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 revenue 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 was successful because its customers— travelers, airlines, and hotels—were exploiting opportunities to make themselves better off by using its services. Priceline 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’s networks of hotels to find a hotel rather than doing the research themselves. They gain from using Priceline’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’s network rather than trying to contact potential customers directly. Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 1 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 opportunities that had been pioneered by Priceline. 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 exploited an opportunity to use resources more efficiently. It is inefficient to have empty hotel rooms and airline seats if someone is willing to pay some price to use them on short notice. 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 did—improves efficiency. Principle 9: When markets don’t achieve efficiency, government 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 economy 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? 21/08/17 10:01 am 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 consumers want and fewer of the types of cars that fewer consumers want. 3. Before lean manufacturing innovations, Japan mostly sold consumer electronics to the United States. How did lean manufacturing innovations alter Japan’s comparative 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 consumer electronics. After the innovations, Japan’s comparative advantage vis-à-vis the United States shifted to auto production. 4. How do you think the shift in the location of Toyota’s production from Japan to the United States has altered 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. What accounts for the fact that before Uber’s arrival, there were typically enough taxis available for everyone who wanted one on good weather days, but not enough available on bad weather days? Suggested Solution 1. Before Uber’s arrival fares were set by city regulators. If everyone who wanted a taxi during good weather could get one, then we can imply that the price set by regulators was approximately equal to the marketclearing price on good weather days. But bad weather, like a snowstorm, produces two changes to supply and demand: an increase in demand (a rightward Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 2 shift of the demand curve) as more people want rides, and a decrease in supply as more taxi drivers want to stay warm and dry at home (a leftward shift of the supply curve). As a result of these two shifts, the market-clearing price rises. But because the actual price was set by regulators and could not increase in the pre-Uber days, a shortage of taxis arose. 2. How does Uber’s surge pricing solve the problem? Assess Kalanick’s claim that the price is set to leave as few people possible without a ride. Suggested Solution 2. Uber’s surge pricing solves this problem because it allows drivers to charge higher prices until supply equals demand. The higher price 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—more people want rides than are available. 3. Use a supply and demand diagram to illustrate how Uber drivers can cause prices to surge by taking coordinated breaks. Why is this strategy unlikely to work in New York, a large city with an established fleet of taxis? Suggested Solution 3. By taking coordinated breaks, Uber drivers in San Diego reduce the quantity supplied at every price. That is, they shift the supply curve leftward. As a result, more riders want rides than are available, and surge pricing kicks in. This is unlikely to work in a large city with an established fleet of cars like New York City. First, because it would be too difficult to coordinate a large enough group of Uber drivers to affect the price. And second, taxi drivers would take the fares when Uber drivers took breaks, preventing a surge in the Uber price. Price (dollars per mile) S (during break time) S P2 E2 E1 P1 D Q2 Q1 Quantity of taxi rides (millions of miles) 21/08/17 10:01 am CHAPTER 4 1. Use the concepts of consumer surplus and producer surplus to analyze the exchange between Jay-Z and Beyoncé and their fans in the absence of ticket resellers. (That is, assume that everyone buys a ticket directly and goes to the concert.) Draw a diagram to illustrate. Suggested Solution 1. By pricing tickets below the market equilibrium price, Jay-Z and Beyoncé transfer some of their producer surplus to their fans. The fans who receive this extra surplus are the ones who purchase their tickets directly, either from the venue box office or from a direct seller like Ticketmaster. So fans receive higher consumer surplus while Jay-Z and Beyoncé receive lower producer surplus compared to the market equilibrium allocation. In the accompanying diagram, the supply curve for tickets is drawn as a vertical line: the supply of tickets for a concert is fixed at the number of seats available at the venue, here QE. The demand curve is downwardsloping as lower ticket prices encourage more fans to buy tickets. The market equilibrium is at point E, with a market price of PE and a quantity bought and sold of QE. Pricing tickets at a price PC that is below the market equilibrium price 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 S X Y A PC Z B Shortage QE 2. If all fans bought tickets from resellers, then the price of tickets would rise to the market equilibrium price of PE. Look again at the diagram accompanying solution 1. As the price rises from PC to PE, consumers 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 Jay-Z and Beyoncé and area Y is captured by resellers. In this case, fans are not rewarded for their loyalty. CHAPTER 5 1. How did lenders benefit from the restriction on the number of New York City taxi medallions? Suggested Solution 1. Lenders benefit from the restriction on the number of taxi medallions because as the price of taxi medallions goes up, purchasers have to borrow more. Hence the demand for loans increases. In addition, loans are secured by the medallions that were purchased using the lent funds. If the borrower is unable to pay, she has to surrender the medallion to the loan company. Hence those loans are worth more as the prices of medallions climb. So since fewer medallions lead to higher medallion prices, the lenders clearly benefit from the restriction on the number of medallions. Suggested Solution D Quantity of tickets If tickets were priced at the market equilibrium price PE, consumer surplus would be lower (area X), and producer surplus would be higher (the sum of areas Y and Z). In other words, the amount of consumer surplus given by area Y is Jay-Z and Beyoncé’s gift to fans for their loyalty. It is also the money Jay-Z and Beyoncé forfeit by pricing tickets below the market equilibrium price. Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 3 Suggested Solution 2. Use a graph to illustrate the effect of the entry of Uber on the incomes of taxicab drivers. Assume that Uber cars cannot pick up fares hailed from the street and that there are some people who prefer to hail cabs rather than use an app. How does your graph change if that restriction is lifted? E PE 2. Using the diagram drawn in response to question 1, explain the effects of resellers on the allocation of consumer surplus and producer surplus among Jay-Z and Beyoncé and their fans. 2. To devise your graph, take Figure 5.9 as it is, then add to it a vertical line at 9 million rides, and arrows showing a horizontal shift from the vertical line at 8 million to the line at 9 million. Label the upper point on the 9 million line graph as C (at $5.50 fare) and the lower point as D (at $4.50 fare). Draw in the dotted 21/08/17 10:01 am lines from the vertical axis to points C and D. Label the shift “Uber Effect” with a balloon. Fare (per ride) Quota 1. The price elasticity of demand for airline flights is inelastic. We know this because airlines were able to increase their revenues and profit by reducing supply and increasing price. S $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 0 Uber effect Suggested Solution A 2. Using the concept of elasticity, explain why airlines would create such great variations in the price of a ticket depending on when it is purchased and the day and time the flight departs. Assume that some people are willing to spend time shopping for deals as well as fly at inconvenient times, but others are not. C E D B D 6 7 8 9 10 11 12 13 14 Quantity of rides (millions per year) The entry of Uber into the taxicab market will increase the number of rides offered. As shown here, the entry of Uber shifts the vertical line indicating the quota rightward. As a result, the quota rent going to the owner of a medallion falls. Here we have shifted the quota line from 8 million rides pre-Uber to 9 million rides post-Uber, and the quota rent falls from $6 − $4 = $2 to $5.50 − $4.50 = $1. The $1 represents the quota rent that medallion holders still receive because some people still prefer to hail taxicabs rather than use Uber cars, and the number of taxicabs is still restricted. However, if the rules are changed and Uber cars are also allowed to pick up fares hailed from the street, the market will move to equilibrium E because the quantity control will have been completely eliminated. As a result, the quota rent will disappear. 3. Why has the fight between Uber and the taxicab industry turned political? Suggested Solution 3. It is predictable that the fight between Uber and the taxicab industry turned political because restrictions on how many cars can sell rides in New York City are creations of the city government. The taxi industry would like to maintain the quota so it can maintain the quota rents, while Uber would like to circumvent the quota so it can operate. CHAPTER 6 1. How would you describe the price elasticity of demand for airline flights given the information in this case? Explain. Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 4 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 suitcases fly with them or being served drinks onboard, they know they can raise revenue by imposing fees on these services. Airlines often try to hide or disguise these fees to prevent travelers from making substitutions, like choosing a different airline that doesn’t charge for such services. 4. Use an elasticity concept to explain under what conditions the airline industry will be able to maintain its high profitability in the future. Explain. 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 supplied dramatically when demand increases, prices will fall, and their profits will fall as well. 21/08/17 10:01 am CHAPTER 7 1. To save energy and reduce carbon emissions, why do you think that Microsoft instituted a tax rather than issue a company-wide directive? Suggested Solution 1. The use of a tax is likely to be more effective in generating savings and reducing carbon emissions than a directive because the tax provides a direct measurement of employees’ efforts to save energy and reduce carbon emissions. As a result, they can be rewarded more directly through their performance evaluations on their efforts. In other words, a tax works more directly to affect incentives than a directive. 2. How is Microsoft behaving like a government? Why is this preferable to business units acting independently? Suggested Solution 2. Microsoft is collecting tax revenue and spending the money on projects that benefit the entire company much like a government collects taxes and spends the proceeds on projects that benefit society, such as air traffic control. By behaving like a government through its carbon tax scheme, the monies collected on a company-wide basis can be pooled to fund larger projects that benefit the entire company. Business units acting independently will only want to fund projects that benefit their own bottom lines. 3. What is a possible downside to the internal carbon tax scheme? What trade-offs should Microsoft consider in determining the size of the carbon tax? Suggested Solution 3. A possible downside of the tax is that it may distort business decisions by excessively discouraging energy use: for example, employees may limit their business travel, causing the company to miss out on business opportunities that are in Microsoft’s interests. In deciding how high the tax should be, Microsoft must trade off the benefits of energy saving and carbon-emissions reduction with the costs of discouraging energy use when making business decisions. CHAPTER 8 1. Why do you think it was profitable for Li & Fung to go beyond brokering exports to becoming a supply chain manager, breaking down the production process and sourcing the inputs from various suppliers across many countries? Suggested Solution 1. By sourcing inputs from various suppliers across many countries, Li & Fung was able to allocate production to where it is most cost effective. Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 5 2. What principle do you think underlies Li & Fung’s decisions 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 manufacturer in mainland China would not benefit from the gains from trade that arise from sourcing inputs from different countries according to those countries’ comparative advantage. 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 illustrated by this case and explain your choice. Suggested Solution 1. J.C. Penney customers were using the anchoring behavioral strategy, which is a form of bounded rationality. They looked to the pre-sale price as a benchmark to estimate the value of the good and, therefore, the real savings they were getting once the discount was applied. 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-andcoupon strategy were underestimating their opportunity costs. They weren’t actually paying less under the sales-and-coupon pricing strategy, yet they were 21/08/17 10:01 am 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? 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 in 2012, and lose customers. CHAPTER 10 1. How does the McPick 2 promotion resemble a consumer’s optimal choice problem? Suggested Solution 1. The $2 price for the McPick 2 resembles a budget constraint. And the choice of two items resembles how a consumer chooses a bundle of two goods according to his or her preferences in order to maximize his or her utility. 2. What feature of this case study illustrates diminishing marginal utility at work? Suggested Solution 2. We see diminishing marginal utility illustrated by the declining popularity of McCafe beverages. For example, when first introduced, customers experienced a McCafe caramel mocha as a treat. Over time, as more of these beverages were consumed, a caramel mocha was no longer considered something special and so consumption dropped. 3. Give an example of a normal good and an inferior good mentioned in this case. Cite examples of income and substitution effects from the case. Suggested Solution 3. A normal good is a good for which demand rises as income rises; a meal at a fast casual restaurant like Chipotle is an example of a normal good. An inferior good is a good for which demand rises as income falls; fast-food meals at restaurants like McDonald’s are inferior goods. The fall in McDonald’s sales when it eliminated its Dollar Menu illustrates the substitution effect: consumers substituted meals from other sources—whether home-cooked meals or meals at competing, lower priced fast-food chains—in response to the rise in prices at McDonald’s. The income effect is illustrated by the increase in demand for meals at fast Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 6 casual establishments as consumers’ incomes rose with the economic recovery that followed the 2007–2009 recession. CHAPTER 11 1. Describe the shift in Amazon’s cost structure based on the concepts from this chapter. Is Amazon on a shortrun or long-run cost curve? What are the relevant returns to scale in Amazon’s operations? Suggested Solution 1. By substituting robots for human workers, Amazon has reduced its variable costs (labor) and increased its fixed costs (robotic system). Amazon is on its long-run cost curve since it has spent 20 years choosing and refining its cost structure. Amazon is experiencing increasing returns to scale since its average total cost of fulfilling an order is falling. 2. What are the pros and cons of Amazon’s strategy? Suggested Solution 2. On the “pro” side of Amazon’s strategy is that it achieves increasing returns to scale and therefore lower average total cost as sales increase. On the “con” side, the strategy requires very large up-front (fixed) costs. Therefore it can cover its total costs only if it has a large number of sales. If it should for some reason lose a large number of sales, its average total cost would rise significantly. 3. What advantage does a robotic system give Amazon over its rivals? How likely is it that they will catch up with Amazon? What market factors does it depend upon? Suggested Solution 3. Amazon enjoys a cost advantage over its rivals because its investment in a robotic system has given it lower average total cost on its high number of sales. Whether or not its rivals can catch up depends upon whether its rivals can capture enough sales to make a similar investment in a robotic system cost-effective. That is, is the market large enough for a rival like Walmart to invest in robotics and make enough sales that it could reduce its average total cost to the same level as Amazon? That is the question! 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 comparison shopping via mobile app? 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 21/08/17 10:01 am retailers. In perfect competition every transaction at the market equilibrium takes place at the same price. The major impediment to competition was customers’ inability to compare prices across various retailers, which would have required them to go to or call several stores. 2. What effect is the introduction of shopping apps having on competition in the retail market for electronics? On the profitability of brick-and-mortar retailers like Best Buy? What, on average, will be the effect on the consumer surplus of purchasers of these items? Suggested Solution 2. The introduction of these apps will make the retail market for electronics much more competitive, which will reduce the profitability of brick-and-mortar retailers like Best Buy. The consumer surplus of purchasers will increase because, on average, they now pay a lower price. 3. Why are some retailers responding by having manufacturers make slightly modified or exclusive versions of products for them? Is this trend likely to increase or diminish? Suggested Solution 3. By carrying products exclusive to their shelves, retailers can foil mobile-app 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 mobileapp comparison shoppers. CHAPTER 13 1. What is the source of surplus in this industry? Who generates it? How is it divided among the various agents (author, publisher, and retailer)? Suggested Solution 1. To understand the source of the surplus in this industry, note that the production is the writing of books by authors. Surplus is created by trade between authors who write books and readers who enjoy reading them. Publishers may improve the product by providing editing, marketing, etc., but the ultimate source of production is in the hands and minds of authors. Now imagine a world in which every author’s style of writing is the same. In such a world, nothing would differentiate a thriller written by Ms. Dagger versus one written by Mr. Cloak. Books would be like commodities, making the book industry perfectly Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 7 competitive. The equilibrium price of books would settle at a level that leaves authors indifferent between writing a book or not. In this world, all of the surplus accrues to readers. Note that readers, who value variety, education, and quality in their books, may not enjoy this world very much. But the real world does not operate this way. Authors do indeed write in different ways. Successful authors write well enough that their books command a price that allows them to capture some of the market surplus (and like Douglas Preston, to live a comfortable lifestyle). Moreover, efforts by publishers in the form of editing, advertising, etc., can increase the share of the surplus going to the author by raising readers’ willingness to pay for a given book. Total surplus is higher 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 investors who have bankrolled these investments on the promise of future profits. Amazon also has market power through economies of scale. As Amazon attempts to capture a larger share of the market surplus, successful authors and their publishers are at risk of losing surplus to Amazon. Moreover, if publishers are at risk of being forced out of business, successful authors fear that a source of their success will disappear. Amazon investors are impatient after financing many years of large losses. So the pressure is on Amazon to deliver steady returns. If Amazon is unable to deliver those returns, it would have to curtail its investments in new warehouses, robots, video development, and web services—all sources of its retail dominance. 21/08/17 10:01 am 1. Explain why Virgin Atlantic and British Airways might collude in response to increased oil prices. Was the market conducive to collusion or not? 3. What explains the popularity of the Dollar Shave Club? What dilemma does Schick and Gillette face in deciding to create their own lines of inexpensive subscriptionbased razors? What does this indicate about the welfare value to customers of the innovation in razors? Suggested Solution Suggested Solution 1. They may have wanted to collude because it was reasonable to fear that if one of them raised its price, the other would not and so cause a price war. The market was conducive to collusion because so much of it was dominated by British Airways, making it a natural price leader. 3. The popularity of the Dollar Shave Club can be explained by its lower prices. For customers who find store-bought razor cartridges too expensive or that upgraded features are not worth the cost (those who are welfare reducing), DSC offers an appealing alternative. The dilemma that Schick and Gillette face in creating their own lines of subscription-based razors is that these cheaper models can cannibalize sales of the newer, more complex ones. But if Schick and Gillette don’t expand their offerings to include an inexpensive online service, a competitor could, and very well might, undercut them. CHAPTER 14 2. How would you determine whether illegal behavior actually occurred? What might explain these events other than illegal behavior? Suggested Solution 2. For the airlines’ actions to have been illegal, it would have been necessary for the two companies to make an agreement to coordinate price increases. If one imposed the surcharge and the other merely followed suit, their actions would not have been illegal. CHAPTER 16 3. Explain the dilemma facing the two airlines as well as their individual executives. 1. What type of externality is present in social networking platforms, or SNPs? Explain why Friendster and Facebook, two SNPs that were direct competitors, were unlikely to both survive. Explain why the loser, Friendster, declined so quickly. Suggested Solution 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. 1. A social networking platform, or SNP, is an example of a network externality: the desirability of its use increases the larger the number of other people using it. So when two SNPs are in direct competition, one will eventually come to dominate, and the other one will decline into insignificance. The loser will decline quickly because as each user leaves, the value to staying of all other users of that network will fall. So there will be a cascade of departures. CHAPTER 15 1. What explains the complexity of and high rate of innovation in razors by Gillette and Schick? Suggested Solution 1. The complexity of razors and pace of innovation in their features are a reflection of the intense non-price competition between Schick and Gillette. 2. Why is the razor business so profitable? What explains the size of the advertising budgets of Schick and Gillette? Suggested Solution 2. The business is so profitable because Schick and Gillette have been able to convince customers to pay higher prices for more complex razors and for blade cartridges. Schick and Gillette have large advertising budgets to accomplish this. Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 8 2. Explain how, in the past few years, the nature of the externality has been altered by privacy concerns, especially among teens. Why does this change lead to greater fragmentation of users across the different platforms? Suggested Solution 2. The nature of the externality has been altered from the rise of privacy concerns—concern that your grandmother, or your future employer, may see your posts. This ultimately disadvantages Facebook relative to SNPs that preserve privacy, like Instagram and Snapchat. Thus, at some point bigger is no longer better, leading to fragmentation across platforms in spite of the network externality. 3. Why do SNPs face a persistent dilemma in generating revenue? 21/08/17 10:01 am Suggested Solution 3. SNPs can generate revenue only by using pop-up ads. However, ads annoy users and motivate them to move to another platform without ads. However, each platform ultimately needs to generate revenue because it cannot operate indefinitely on borrowed money. 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 exploitation means fewer animals and less grazing area for them. Without some economic incentive to conserve the wildlife and their grazing lands, Kenyans will overuse them, leading to huge losses. 2. Compare the economic incentives facing John Hume with those facing a Kenyan rancher. Suggested Solution 2. Hume’s ownership of a large ranch and the animals on it means that he now has property rights on the common resource, leading him to efficiently maintain that resource. A Kenyan rancher, who cannot own the wildlife found on his or her land, cannot earn income from the animals and so has an incentive to overuse the common resource: killing the wildlife and turning grazing areas into income-producing farmland. 3. What regulations should be imposed on a rancher who sells opportunities to trophy hunt? Relate these to the concepts in the chapter. 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. What pattern would you expect to see in the size and number of newly created companies after 2014 and the implementation of the ACA? Suggested Solution 1. After the implementation of the ACA, there should be an increase in the number of smaller-sized newly Krugman_Micro_5e_BCS_BCS1-BCS10_Final.indd 9 created companies. Because new companies tend to be small in any event, the United States should see an overall increase in the number of companies created. 2. Historically, smaller companies and entrepreneurs have been more innovative than larger companies. What does this imply for the rate of innovation in the United States before the ACA? After the ACA? Suggested Solution 2. With a higher number of small companies created, and more entrepreneurs freed to follow their objectives, the rate of innovation in the United States should be higher after the ACA than before its implementation. The evidence on job/entrepreneur lock indicates that innovation was diminished in the United States by the inability of individuals to get adequate health insurance. CHAPTER 19 1. Use the marginal productivity theory of income distribution to explain how companies like Walmart can pay workers so little that they fall below the poverty line. 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. Prior to 2015, Walmart had designed its business so that this was the case. For example, Walmart at one time touted its low prices but not its customer service. As a consequence of paying low wages, Walmart had high worker turnover. And high worker turnover meant that the average Walmart worker had a low value of marginal product because she had not acquired job skills or experience. 2. Use the case to explain how similar workers in the same labor market can end up being paid different wages in equilibrium. Also explain why Walmart believed it could improve its profitability by raising its labor costs. Suggested Solution 2. Both Costco and Walmart are hiring workers with a similar skill set. But that doesn’t mean each worker is paid the same, even in equilibrium. The quantity of labor demanded by each firm is a function of worker productivity within each company. Costco has recognized that paying above equilibrium wages, or efficiency wages, has resulted in a more productive labor force. The equilibrium wage corresponds to marginal productivity of the last worker hired, not all workers. By raising wages, Walmart is inducing its workers to be more productive. Ideally, the higher 21/08/17 10:01 am wage will result in sufficient improvement in customer service, store cleanliness, and the high turnover rate, to generate enough revenue to increase profits. 3. Some politicians want to encourage more companies to adopt a high-wage strategy. What are the possible positive and negative effects of such a policy? Suggested Solution 3. If government policy encourages more companies to act like Walmart, paying higher wages to induce workers to be more productive, the gains would be direct: higher earnings for many workers, with many of the beneficiaries being workers who would otherwise have been poorly paid. Also, to the extent that the strategy works, the economy as a whole would become more productive and richer. There are two possible downsides. First, what apparently works for Walmart might not work for everyone, so costs would rise—and this cost increase would be passed on in the form of higher prices. Second, companies could end up hiring fewer workers in total, raising the natural rate of unemployment and hurting those workers who are shut out. CHAPTER 20 1. What is one example of moral hazard by homeowners in hurricane-prone areas? Explain. Suggested Solution 1. Homeowners who purchase homes in hurricane-prone areas under the assumption that their potential losses would be covered by insurance are engaging in moral hazard. That is, they took a risky action (purchasing in such a location) that they may not have undertaken if they had to incur the losses from hurricane damage on their own. Another example of moral hazard is offered by homeowners living in hurricane-prone areas who fail to invest adequately in hurricane-proofing their homes because their losses would be covered by insurance. 2. How does the case illustrate market failure due to adverse selection? selection arose because they were unable to differentiate houses according to the expected cost of a claim— they couldn’t tell a house that was expected to withstand a hurricane with little loss from one that might incur a high loss. As a result, they couldn’t adjust their premiums to accurately reflect the risk. Rather than risk suffering extensive losses, insurance companies extensively cut back on writing policies. 3. What were the sources of Buchmueller’s innovation that allowed him to succeed in the presence of moral hazard and adverse selection? Suggested Solution 3. Buchmueller innovated by acquiring information that allowed him to limit the costs of moral hazard and adverse selection. By insuring only newer homes that were verified as hurricane-proof, he did not have to ascertain whether or not a homeowner had been underinvesting in hurricane defenses. This avoided the moral hazard problem. Likewise, by studying the history of claims, he discovered what were good risks (newly built, high-value, hurricane-proof homes) versus poor risks (older, less expensive, hurricanevulnerable homes). This solved the adverse selection problem. 4. Why did Buchmueller purchase insurance policies from big, global insurance companies to cover up to 75% of his own losses? What principal does this illustrate? Suggested Solution 4. By insuring up to 75% of his potential losses with big insurance companies, Buchmueller was able to maintain a smaller fund for paying claims than he might have otherwise, allowing him to lower his cost of capital. This illustrates the principle of diversification. Because the big insurance companies had large portfolios that were diversified globally, they could treat the risk of Florida hurricane losses as small. Thus they were willing to sell insurance to Buchmueller’s company at a price Buchmueller was willing to pay. Suggested Solution 2. Market failure occurred when insurance companies reduced the number of insurance policies they were writing in Florida’s hurricane-prone areas. Solution Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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