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					ECON 120              ECONOMIC DEVELOPMENT                                  MIDTERM EXAM
                          SPRING 2007

Section A: Computations & Short Answers (60%)
Answer ANY THREE questions in this section concisely with all relevant workings shown clearly for
full credit (60 points). All questions in section A carry equal weight (20 points)

1. Define and discuss the following terms in the context of this course. Although not required, use
diagrams where appropriate. In the case of theories and models, explain the basic assumptions and
conclusions associated with them.

a. Economic Development

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Economic Development is the process of improving the quality of all human lives. Three equally
important aspects of development are: (1) raising people’s living levels – their incomes and
consumption levels of food, medical services, education, etc. through relevant economic growth
processes; (2) creating conditions conductive to the growth of people’s self-esteem through the
establishment of social, political, and economic systems and institutions that promotes human dignity
and respect; and (3) increasing people’s freedom by enlarging the range of their choice variables, as by
increasing varieties of consumer goods and services.

b. The “market friendly” approach towards development

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This approach recognizes that there are many imperfections in LDC product and factor markets and
those governments do have a key role to play in facilitating the operation of markets through
“nonselective” (market-friendly) interventions – for example, by investing in physical and social
infrastructure, health care facilities, and educational institutions by providing a suitable climate for
private enterprise. This approach differs from the free-market and public-choice school of thought by
accepting the notion that market failures are more widespread in developing countries in areas such as
investment coordination and environmental outcomes.

c. Purchasing power parity

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PPP is defined as the number of units of a foreign country’s currency required to purchase the identical
quantity of goods or services in the local (LDC) market as US$ 1 would buy in the US.
It is calculated using a common set of international prices for all goods and services produced, valuing
goods in all countries at US prices.
2. Consider the following data for Bolivia and Iran in 2006. Show clear and complete workings for full

          Country           Population Frying Pans                  Coffee           Price of FP       Price of
                                       (units)                      (packets)        per unit          Coffee ton**
          Bolivia             20,000   4,000                        6,000            25 BOB            40 BOB
          Iran                12,000   9,000                        1,000            10 IR             30 IR

Exchange Rate: 1IR per 2BOB (i.e., 0.5IR per BOB)
**Note that although coffee is sold in packets it is priced at a PER TON level. In this example 20
packets of coffee are equal to a ton. of coffee.

a. Calculate and compare each country’s GDP per capita, expressed in 2006 IR, using the Exchange
Rate Method. Are people in Bolivia richer than in Iran (use GDP per capita as a proxy for incomes)?

                                                                              Iran                                   Bolivia

Production of Frying Pans (Units)                                            9000                                      4000
Price of Frying Pans per unit                                                  10 IR                                     25 BOB

Production of Coffee (Packets)                                               1000                                      6000
Production of Coffee ™ (20 Packets = 1 TM)                                     50                                       300
Price of Coffee per TM                                                         30 IR                                     40 BOB

Population                                                                 12000                                    20000
Exchange Rate                                                     0.5 IR = 1 BOB                              2 BOB = 1 IR

GDP                                                                        91500 IR                                  112000 BOB

Exchange Rate Method

GDP (IR terms)                                                             91500 IR                                   56000 IR
GDP per capita (IR terms)                                                    7.63 IR                                    2.80 IR
* Use the exchange rate to put both GDPs in the same currency.

The GDP per capita of Iran is bigger than the GDP per capita of Bolivia. People in Iran are richer than in Bolivia

b. Now, calculate each country’s GDP per capita in IR for 2006 using the PPP method. Is Bolivia’s per
capita GDP bigger than the one of Iran? Why?

Power Purchasing Parity Method: IR

GDP per capita (IR terms)                                                  7.63 IR                                   2.45 IR
Use vector of prices from Iran for the estimation of the GDP, so both GDPs will be in the same currency.

The GDP per capita of Iran is still bigger than the GDP per capita of Bolivia.
Notice that the production of Frying Pans is bigger than the production of Coffee in both countries, and also
the price of Coffee is bigger that the price of Frying Pans independent of the country (which may reveal similar quality),
and assuming that both products are tradable, then the exchange rate and the PPP must have similar results.
c. Now, calculate each country’s GDP per capita in BOB for 2006 using the PPP method. Is Bolivia’s
per capita GDP bigger than the one of Iran? Why?

Power Purchasing Parity Method: BOB

GDP per capita (BOB terms)                                                   18.92 BOB                              5.60 BOB
* Use only one vector of prices (Bolivia) for the estimation of the GDP, so both GDPs will be in the same currency.

The GDP per capita of Iran is still bigger than the GDP per capita of Bolivia.
As pointed out before, there are no problems with PPP method for estimation of production for comparison of countries
if the goods are Tradables and the quality is pretty much the same (revealed by relative prices).

3. The following income distribution data are for Nigeria.

                                                      Quintile                Percent Share
                                                    Lowest 20%                     1.5%
                                                    Second quintile                2.7%
                                                    Third quintile                 7.8%
                                                    Fourth quintile               19.5%
                                                    Highest 20%                   68.5%

                           Nigeria's total national income: $ 500 million per day
                           Nigeria’s population: 100 million people

a. Graph the Lorenz curve from the Nigerian data given above, carefully labeling the axes. On the axes,
label all values that correspond to the five points that make up the Lorenz curve.

                                                           Nigeria Lorenz Curve

   Percentage of income

                                                                      Lorenz curve


                          40                                                                       31.5

                          20                                             A           12.0

                                0             20                40                   60             80                    100
                                                            Percentage of income recipients
b. Show how to find the Gini coefficient, graphically (do not actually calculate it numerically).

Gini coefficient = A / (A + B) in the previous graph.

See Figure 5-3, page 200 for a similar definition.

c. Suppose that each household makes the average income for its quintile (that is, assume that there is
no inequality within quintiles). Using a poverty line of $1 per day per capita, what is the headcount (i.e.
the measured number of poor people)? What is the average income shortfall (AIS)?

Income                                 500000000 US$
Population                             100000000 people

People per quintile     Total income per quintile   Income per capita       TPG

             20000000                    7500000                 0.38             0.625
             20000000                   13500000                 0.68             0.325
             20000000                   39000000                 1.95
             20000000                   97500000                 4.88
             20000000                  342500000                17.13

H = 40 million people

AIS = [(0.625*20 million) + (0.325*20 million)]/40 million = 0.475

d. Suppose 5% of total national income were transferred from the highest-income quintile of
households to the lowest-income quintile of households. Assume no other changes in the economy.
What quantitative effect does this have on the headcount?

Income                                 500000000 US$
Population                             100000000 people

People per quintile     Total income per quintile   Income per capita 5% Income       Tansfer to poor

             20000000                    7500000                 0.38                            1.2
             20000000                   13500000                 0.68                            0.7
             20000000                   39000000                 1.95                            2.0
             20000000                   97500000                 4.88                            4.9
             20000000                  342500000                17.13         0.856             16.3

H = 20 million people (the second quintile becomes the poorest)
4. The Solow neoclassical growth model.

a. Compare and discuss the production function in the Harrod Domar model with the production
function in the Solow model.

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Y  AK (Harrod-Domar production function)
    AL
Y K ( ) (Solow production function)

The Solow model expanded on the Harrod-Domar formulation by adding a second factor, labor, and
introducing a third independent variable, technology, to the growth equation.
Unlike the fixed-coefficient, constant-return-to-scale assumption in the Harrod-Domar model, Solow’s
neoclassical growth model exhibited diminishing returns to labor and capital separately and constant
returns to both factors jointly.
Technological progress became the residual factor explaining long term growth, and its level was
assumed by Solow to be determined exogenously (independently of all other factors).

b. What are the differences in the conclusions of the Solow model in a closed economy compared to an
open economy?

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Closed economies (those with no external activities) with lower saving rates (other things being equal)
growth more slowly in the short run than those with high savings rates and tend to converge to lower
per capita income levels.
Open economies (those with trade, foreign investment, etc.), experience income convergence at higher
levels as capital flows from rich countries to poor countries where capital-labor ratios are lower and
thus returns on investment are higher.

Section B: Essay Questions (40%)
Answer any TWO questions in this section. Credit will be given for references to the non-textbook
literature. All questions in section B carry equal marks (20 points each)

   1. Using the production function approach, explain which factors are predominantly responsible
   for the large disparity in per worker output between North and South America?
   2. Critically evaluate the models and policy recommendations of the dependency school.
   3. Account for the post-1960 “neoclassical revival” in development thinking.
   4. Critically evaluate some of the major policy recommendations that have been advanced to deal
   with poverty in third world countries.
   5. Are high rates of population growth a drag on the development effort? Which policies should
   be advanced to deal with this problem?
   6. What are the causes of rural urban migration? Should these flows be reduced? If so, what can
   be done to reduce these flows?