ECON 120
ECONOMIC DEVELOPMENT
SPRING 2007
MIDTERM EXAM
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
credit.
Country
Bolivia
Iran
Population Frying Pans
(units)
20,000
4,000
12,000
9,000
Coffee
(packets)
6,000
1,000
Price of FP
per unit
25 BOB
10 IR
Price of
Coffee ton**
40 BOB
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)
Price of Frying Pans per unit
9000
10 IR
4000
25 BOB
Production of Coffee (Packets)
Production of Coffee ™ (20 Packets = 1 TM)
Price of Coffee per TM
1000
50
30 IR
6000
300
40 BOB
Population
Exchange Rate
12000
0.5 IR = 1 BOB
GDP
20000
2 BOB = 1 IR
91500 IR
112000 BOB
91500 IR
7.63 IR
56000 IR
2.80 IR
Exchange Rate Method
GDP (IR terms)
GDP per capita (IR terms)
* 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
Use vector of prices from Iran for the estimation of the GDP, so both GDPs will be in the same currency.
2.45 IR
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
Lowest 20%
Second quintile
Third quintile
Fourth quintile
Highest 20%
Percent Share
1.5%
2.7%
7.8%
19.5%
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
100
Percentage of income
100
80
Lorenz curve
60
40
31.5
A
20
1.5
12.0
B
4.2
0
0
20
40
60
Percentage of income recipients
80
100
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 $1 per day per capita, what is the headcount (i.e.
the measured number of poor people)? What is the average income shortfall (AIS)?
Income
Population
500000000 US$
100000000 people
People per quintile
20000000
20000000
20000000
20000000
20000000
Total income per quintile
Income per capita
7500000
13500000
39000000
97500000
342500000
TPG
0.38
0.68
1.95
4.88
17.13
0.625
0.325
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
Population
500000000 US$
100000000 people
People per quintile
20000000
20000000
20000000
20000000
20000000
Total income per quintile
7500000
13500000
39000000
97500000
342500000
Income per capita 5% Income
0.38
0.68
1.95
4.88
17.13
H = 20 million people (the second quintile becomes the poorest)
0.856
Tansfer to poor
1.2
0.7
2.0
4.9
16.3
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)
YK(AL
)1 (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?