Lahore University of Management Sciences
Mushtaq Ahmad Gurmani, School of Humanities and Social Sciences(MGSHSS)
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Development Economics
ECON 240
Dr. Ayesha Ali
Midterm
2023–24
October 17, 2023
100 minutes
80
The instructions below must be followed strictly. Failure to do so can result in serious grade loss.
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1. Measuring Development [15 points]
1a. Propose three different indicators of development that can be used to assess progress
towards the three core objectives of development outlined in Todaro & Smith (basic
needs, living standards, range of choices). [6 points]
Amartya Sen’s capability approach to development emphasizes the centrality of
opportunities and freedoms as essential components of human development. Consider
large scale urban public transport projects such as the Bus Rapid Transit systems.
1b. What functionings might such a project enable individuals to attain? [3 points]
Being able to access economic opportunities which can then lead to functionings such as
earning a decent living, enjoy good living standards
Being able to access health and education services which can lead to functionings such as
being healthy, being well-educated
Being able to commute for social/personal reasons that can lead to functionings such as
being valued, being connected and feelings of well-being
Being able to access markets (goods and services) that can lead to functionings such as
enjoying good living standards
There might be negative externalities of such projects for some people which can
deteriorate their functionings e.g. those who are displaced might lose their shelter, those
in adjacent areas might suffer noise, congestion and other forms of pollution.
1c. Would such a project enhance individual capabilities? [3 points]
If individuals (especially women or other marginalized groups) enjoy social freedom e.g.
no restrictions on movement then capabilities can be enhanced
But there might be limits to freedoms e.g. social barriers, harassment, crime, safety
concerns that can prevent individuals from fully enjoying the opportunities that can be
afforded by such projects
1d. Propose a complementary program/policy to public transport systems that can enable
expansion of individual capabilities. [3 points]
Ensuring security for sensitive groups e.g. having women-only buses or designated safe
spaces.
Public education programs to affect norms/culture and increase social freedoms for all
groups using transport
2. Growth Models [15 points]
2a. Why are some countries rich and other countries poor? For each of the models below
explain the key insights that the model develops to answer this question. [10 points]
(Note: Differences in living standards are due to differences in growth rate of income per
capita that can lead to some countries enjoying very high living standards while others
become stagnant).
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(i)
(ii)
(iii)
(iv)
(v)
Harrod-Domar model
Differences in saving rates explain differences in growth rates and living
standards across countries. Assuming that economies have similar capital to
output ratio, depreciation and population growth, saving (for investment in
capital) becomes a key driver of growth, as in the Harrod-Domar model
marginal product of capital is constant.
Solow growth model with technology growth
Capital accumulation can not be a source of growth in the long run. Increase
in saving can provide a temporary boost to growth but as diminishing returns
to capital set in, the economy’s long run/steady state growth rate will depend
on the rate of technological progress. In the long run economies grow at the
rate of growth in technology.
Endogenous growth models
The rate of growth in technology depends on firms/sectors that are engaged in
the production of new technologies and ideas. The accumulation of capital
(via saving and investment) in these sectors creates external benefits for all
firms and, thus the aggregate production function has increasing returns to
capital. Countries where such firms/sectors flourish successfully will enjoy
high growth rates and living standards.
Long-run/historical approaches to explaining growth
Accidents/events from history can influence development and growth of
countries even today as such events can have long-term effects (idea of path
dependency). For example, colonials set up extractive institutions that create
inequality in incomes, justice and human development in countries where
settler mortality was high (South Asia, Africa, Latin America). These
conditions perpetuate over time and leading to low socio-economic
development.
Dependence theories
Underdevelopment is an externally induced phenomenon. developed and
developing countries are locked into a dependence-dominance relationship.
One of the manifestations of this is in international trade where developed
countries due to their political power extract primary resources/commodities
at very low prices from developing countries and developing countries are
buying imported goods, capital, technologies at very high prices. This
perpetuates trans-national income inequalities over time.
2b. What does the Solow model predict about the growth in living standards of two
economies, one of which starts far below the steady state and the other one which starts
close to the steady state? Assume that both economies have similar parameters that
determine the actual steady state. [3 points]
The economy which is far below the steady state will grow faster than the economy
which is closer to the steady state.
This is because the change in capital per capita is greater the farther away you are from
the steady state. Capital deepening (sf(k)) is greater than capital widening ((d+n)k) at low
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levels of capital as the returns to capital are higher. As economies accumulate more
capital diminishing returns set in and the distance between (sf(k)) and (d+n)k) narrows
down thus change in capital per capita falls as we move closer to the steady state.
2c. Propose a test of the Solow model based on your answer above [2 points]
We can examine the growth in income per capita or capital per capita as a function of
initial conditions, for example, are countries that started out with low levels of income
per capita or capital per capita showing faster growth or not. This is called relative
convergence in living standards.
2d. The graphs below show the growth in income per capita between 1980-2007 of
developing countries and the OECD countries as function of initial income per capita in
1980.
2e. Does the evidence in these graphs support the predictions of the Solow model? [5
points]
The first graph shows a slight positive association between income per capita in 1980 and
the subsequent growth in per capita income between 1980-2007 for a sample of 86
developing countries. There is no evidence of relative convergence among developing
countries contradicting the Solow model.
The second graph shows a negative relationship between income per capita in 1950 and
the subsequent growth in per capita income between 1950-2007 for a sample of 22
OECD countries. This graph supports the Solow model’s prediction of relative
convergence.
One interpretation is that the OECD countries have similar economic parameters, e.g.
production technology, saving, depreciation and population growth and thus they follow
a path of relative convergence as predicted by Solow model. While developing countries
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can be widely different from one another and thus we would not see the Solow model
predictions hold true.
3. Underdevelopment due to Multiple Equilibria [20 points]
Privately rational investment
The graph reflects the investment decision of a worker acquiring modern skills as a
function of the expected investment of all other workers in such skills.
C
B
A
Expected investment
3a. Which feature of this graph reflects complementarities in the decision problem of the
workers? [1 point]
The curve showing the optimal investment decision of workers is upward sloping which
reflects that they would like to increase investment in response to observed/expected
increases in investment.
3b. Which feature of this graph gives rise to multiple equilibria? [2 points]
The S-shape or having a portion of the curve which cuts the 45 degree line from below
and another portion that cuts the 45 degree line from above. This reflects that the
privately rational investment is first increasing at an increasing rate in expected
investment and eventually increases at a diminishing rate.
3c. Which equilibria are likely to arise in practice? Explain using the graph. [5 points]
A- If initial expected investment is to the left of B, then the optimal decision of the
worker will be to invest less than this amount. When this is observed by other
workers they lower their investment to match it. There will be a downward
convergence of investments to A.
B- Unstable equilibrium – will not arise in practice.
C- If initial expected investment is to the right of B, then the optimal decision of the
worker will be to invest more than this amount. When this is observed by other
workers they increase their investment to match it. . There will be a downward
convergence of investments to B.
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3d. Propose two policies that can help the workers achieve the high investment
equilibrium. [2 points]
Government invests or subsidizes worker investment such that initial investment rises to
B.
Workers set up a coordinating mechanism e.g. worker association to jointly determine
investment.
Government policies which create expectations that investment will be B or greater than
B.
3e. Give one other example discussed in class that can explain the existence of chronic
poverty due to multiple equilibria. [5 points]
Can discuss either the capacity curve example or income dynamics example discussed in
class. Key points:
-S-shape relationship between variables with contexutualization relevnant to the example
(2 points]
-Explaining which parts of the graph lead to a trap and which parts result in escaping the
trap [2 points]
-graph [1 point]
3f. What was the Millennium Villages Project and explain how its design was meant to
address underdevelopment due to multiple equilibria? [5 points]
Designed specifically for poor rural communities in Sub-Saharan Africa with chronic
poverty and poor socio-economic indicators.
Architects of the project viewed these communities as being stuck in a poverty trap due
to disease environment, landlocked geography and low levels of development of critical
sectors such as schools, hospitals, infrastructure, agriculture etc.
MVP aimed to lift these communities out of poverty through a big push approach by
undertaking coordinated investments in multiple sectors such as health, education,
agriculture, infrastructure, and access to clean water and sanitation.
The idea was that if such investments can be taken in a coordinated manner we can lift
poor people out of poverty by ensuring that they have access to basic needs, economic
opportunities and can invest in human development.
4. Poverty and Inequality [25 points]
4a. The BISP unconditional cash transfer program is part of Pakistan’s national social
protection strategy for the poor. Explain which design feature of the program enables it to
reach the intended beneficiaries. [5 points]
Targeting poor households and specifically women via a national socio-economic
registry. The registry is based on a poverty census (2019-21) that covered 35 million
households and obtained information about households living conditions, assets,
economic activities and consumption.
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The poverty census data is used to calculate the poverty score for every household. Only
households falling below a pre-specified poverty score threshold are deemed eligible for
assistance. This process provides and objective and quantifiable way to determine which
households are designated as the beneficiaries of the BISP program.
4b. Give two limitations of such cash transfer programs in lifting people out of poverty.
[2 points]
Poverty scores are calculated using household’s asset and consumption data which was
costly and time consuming to collect and can become outdated as people transition in and
out of poverty
It provides relatively small cash transfers that can meet consumption needs but might not
help people move out of poverty
4c. What type of program would be useful for lifting people who are chronically poor out
of poverty? Explain in light of the evidence discussed in class. [5 points]
The evidence discussed in class e.g. BRAC Targeting the Ultra Poor program show that
people might be poor because they are stuck in a poverty trap. The bi-modal asset
distribution and dualistic economic activity structure in rural economies suggest the
existence of poverty traps. [1 point for correctly identifying this program]
Poverty graduation programs can be helpful as they target multiple aspects of poverty
They address immediate needs by providing cash assistance, but also address the issue of
poverty trap by providing an asset (e.g. livestock) that can be used by the household for
income generation. The asset transfer can act as a big push and sustainably lift people out
of chronic poverty.
In addition Poverty graduation programs focus on imparting financial/business skills for
poor households and supporting their social integration within communities.
Imagine a small town with a population of 1,000 residents. You're tasked with calculating
the poverty rate in this town using a poverty gap measure. The poverty line is defined at
an income of Rs. 12,000 per month. You have data on the incomes of the residents, and
it's distributed as follows:
200 residents have an income of Rs. 8,000 per month.
300 residents have an income of Rs. 10,000 per month.
250 residents have an income of Rs. 12,000 per month.
150 residents have an income of Rs. 15,000 per month
100 residents have an income of Rs. 18,000 per month
4d. Find the average income required to raise a poor person out of poverty. [5 points]
AIS = TPG/H
𝐻
𝑇𝑃𝐺 = ∑ 𝑦𝑝 − 𝑦𝑖
𝑖=1
There are 500 residents below the poverty line. 200 have a poverty gap of Rs. 4000 each.
300 have a poverty gap of Rs. 2000 each. TPG is Rs. 800,000 plus Rs. 600,000. AIS or
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the average income required to lift a poor person out of poverty is thus Rs. 1400,000/500
=Rs. 2800.
4e. Find the Kuznets ratio for measuring income inequality in this town using the income
shares accruing to top 20% and bottom 40% of the population. [5 points]
*Total income of the town = Rs.11,650,000
Income of the top 20% (200 residents) = Rs. 18,000*100 + Rs. 15000*100 =Rs. 3300,000
Income of the bottom 40% (400 residents) = Rs. 8000*200 +Rs. 10000*200=RS.
3600,000
Kuznets ratio = Rs. 3300,000/ Rs. 3600,000 =0.92
4f. How would you track progress on poverty and inequality reduction? [3 points]
Any three points below:
We should measure the income distributions over time. [1 point]
We should track progress on poverty using a measure such as FGT -2 that is sensitive to
both the severity and distribution of poverty, as it places more weight on individuals
farther from the poverty line. [1 point]
Inequality can be tracked using any complete measure, but some common measures are
Gini and Kuznets ratio. [1 point]
Also acceptable: We could also track intergenerational mobility in terms of incomes or
other socio-economic indicators over the long run.
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