Sample Mid-Term Examination

ARE/ECN 115A: Development Economics

MULTIPLE CHOICE

1. GNI is computed as the total value added earned by residents of a country without making deductions for
a. depreciation.
b. net factor income from abroad.
c. cost of goods produced in one sector but used as an input in a different sector.
d. cost of intermediate goods.

2. Endogenous growth theory attempts to explain

a. the rate of population growth within a country.
b. the rate of capital accumulation within a country.
c. the factors that determine the size of the Solow residual.
d. why there are diminishing returns to capital.

3. The absolute poverty line

a. decreases as real income grows.
b. shows the average income of the lowest income group.
c. can be measured with the Lorenz curve.
d. None of the above.

4. Kuznets’ inverted-U
a. appears to be due to a Latin America effect.
b. suggests that inequality worsens with environmental degradation.
c. suggests that inequality will improve and then worsen as a country grows.
d. explains why poor countries have less income equality than rich countries.

5. Assuming that the Gini coefficient for Egypt is 0.403 and the Gini coefficient for Australia is 0.404, it is
possible to conclude that both Egypt and Australia have
a. virtually the same number of households in absolute poverty.
b. virtually the same percentage of households in absolute poverty.
c. virtually the same degree of income polarization.
d. None of the above.

6. The total poverty gap is the

a. absolute number of people below the international poverty line.
b. percentage of the population below the international poverty line.
c. consumption (measured in dollars) necessary to bring everyone living below the poverty line up to the
poverty line.
d. percentage of a country’s total consumption necessary to bring everyone in the country living below the
poverty line, up to the poverty line.

SHORT ANSWER
1. Identify the three major ingredients in economic growth. Circle the ingredient that contributes most to the
growth process. [4]
(i) capital accumulation (ii) growth in the labor force (iii)technological progress

2. Briefly define Sen’s concepts of: [6]

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 a. Functionings: “what a person does (or can do) b. Capabilities: “the freedom that a person has in
with the commodities of given characteristics terms of the choice of functionings, given his
that they come to possess or control” personal features...and his command over
commodities”
3. Describe briefly how the concept of opportunity costs helps to explain common patterns of primary school
enrollment in developing countries. [3]

If the benefit of the activity the child foregoes by attending school is high, the opportunity cost is high. For
example, if the child can work and earn money for the family instead of going to school, the opportunity cost
could be high.

4. Human Development Index (HDI)

a. What three indicators make up the HDI? [3] Education, life expectancy and income

b. The 2003 Human Development Report reported that the HDI of Botswana was 0.614 (ranked 125th) and
that of the Philippines was 0.751 (ranked 85th). Botswana’s per capita income (PPP) was $7,820 and
that of the Philippines was $3,840. Identify and describe one possible cause for these differences
between the Philippines and Botswana. (No prior knowledge of these two countries is required.) [3]

Since Botswana has a higher income but a lower HDI than the Philippines, the Philippines must have
either higher education or expectancy – or both – than Botswana. In reality, the Philippines has stronger
political and legal institutions, which help it translate less income in to better human development
outcomes.

PROBLEMS [40 POINTS TOTAL]

1. You love to cook and love to travel. Your favorite meal to cook is a seven course fusion of French, Indian
and Mexican cuisine. In Davis, this meal costs you $45 to prepare. You insist on cooking this meal for your
local hosts everywhere you travel. During the past month, you have traveled to three countries and prepared
this meal just like you do in Davis and in the same proportions in each country. Your total food costs for this
meal are as follows:
Country Cost of Meal PPP Rate Official Exchange Rate
(US$/currency) (US$/currency)
Austria 60 Euros $45/60E = 0.75 ($/Euro) 1.58
Kenya 1,000 Kenyan Shillings $45/1000 KS = 0.045 ($/shilling) 0.02
Fiji 45 Fijian Dollars $45/45F$ = 1 ($/F$) 0.67

a. Compute the implied PPP rate for these currencies (e.g., US$/Euro) and complete the PPP Rate column
in this table. [3]

b. Compare your computed PPP rate to the official exchange rate for each currency. [3]
(i) Based on this comparison, explain the pattern of differences between the two rates.

The PPP rate for Austria is lower than the official rate, while those of Kenya and Fiji are above the
official rates. This pattern emerges because, compared to the U.S., non-tradables are more
expensive in Austria and less expensive in Fiji and Kenya.

(ii) Why does this pattern of differences matter in development economics?

When the PPP rate is much higher than the official exchange rate, then GDP calculated using
official exchange rates underestimates GDP for the country – and overestimates the amount of
poverty. Because things cost less in poor countries than they do in rich countries, PPP rates matter
in development economics because the focus is on poor countries and comparisons among countries
at different income levels.
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 c. Food prices are currently skyrocketing at the same rate around the world (including in Davis). Suppose
that Fiji began subsidizing many of the ingredients in your meal in order to keep food prices constant
and avoid food riots, but other countries did not. [3]
Country How would PPP rates change in this scenario?
Austria Stays the same.
Kenya Stays the same.
Fiji Increases.

2. The following income distribution data are for Brazil.

Percentile Share of Income Below
20th 3%
40th 8%
60th 19%
80th 37%
90th 54%
a. Carefully graph the Lorenz curve for this income distribution. Label the axes. [6]

100%

53.8%

0 20% 40% 60% 80% 90% 100%

b. A Lorenz curve always lies _below_ the 45 degree line. Explain why. [3]

For a point to be above the 45 degree line would mean that, for example, 50% of the population earned 51%
of the income. The highest percentage of income that the 50% can earn is 50% because the individuals in
the population have been ordered by income from poor to rich. If they were ordered from rich to poor the
line would have to lie ABOVE the 45 degree line.

c. Without trying to compute it, use your graph to explain how to find the Gini coefficient for Brazil. [3]

You would find the area below the diagonal line and above the Lorenz curve, and divide this by the total
area – the triangle – below the diagonal line and above the axes.

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3. Consider the following distribution of income in a 12-person economy, with a high income of 3, a middle
income of 2, and a poor income of 1. There are four individuals in each of these income classes so that
income distribution in the economy looks like this: (1, 1, 1, 1, 2, 2, 2, 2, 3, 3, 3, 3). The poverty line is 1.75.

a. What is the Total Poverty Gap for this economy? [3]

H
=
TPG ∑ (Y
i =1
p − Yi ) =(1.75-1) + (1.75 – 1) + (1.75 – 1) + (1.75 – 1) = 3

b. Suppose rural income grows steadily at 5% annually. Approximately how many years will it take for the
poor in the economy to reach the poverty line? (HINT: Recall that
X T = X 0 (1 + g )T ⇒ ln X T = ln X 0 + T ln(1 + g ) ≈ ln X 0 + Tg ) [3]

1 is the income of a poor person at time zero. For this person to be raised out of poverty, she needs to
earn 1.75. So then

ln X T − ln X o ln1.75 − ln1 ln1.75

T≈ , so T ≈ = = 11.2 years
g 0.05 0.05

c. Suppose Bill Gates decided to eliminate poverty (as measured by this poverty line) in this economy.
Consider how much it will cost Bill to do this in the following scenarios. [4]
(i) The income distribution is known, but it is impossible to know to which income class an individual
belongs. How much will it cost Bill to eliminate poverty?

Bill will have to give 0.75 to bring each of the people with income of 1 up to the poverty line (1.75).
Since he cannot tell which people are poor, he must give each person – poor or not – 0.75. So the total
cost is 0.75 x 12 = 9.

(ii) The income distribution is known and each individual’s income is observable. How much will it
cost Bill to eliminate poverty?

Bill can give 0.75 to the 4 poor people only. Cost: 0.75 x 4 = 3

d. Your answer to (i) is an “untargerted poverty elimination budget”. Your answer to (ii) is a “targeted
poverty elimination budget”. As a percentage, how much of your budget do you save moving from an
untargeted to a targeted approach? [2]

1 – 3/9 = 6/9 = 66.7%

e. In practice, a targeted approach is always preferable, but often difficult. Name one reason why it is
difficult to perfectly target the poor. [2]

There are many reasons. One reason is that it can be difficult to determine exactly what a poor person e
earns. The poor may earn money from unreported sources like informal work, remittances, etc.

Call the Foster-Greer-Thorbecke poverty index Pα for α={0, 1, 2}. Suppose rural incomes increase to 1.5
because of expanded agricultural exports. [1 each]
f. This change would ____ P0. (circle one) Increase Not change Decrease

g. This change would ____ P1. Increase Not change Decrease

h. This change would ____ P2. Increase Not change Decrease

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i. This change would ____ the Gini. Increase Not change Decrease

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4. The Solow Growth Model
a. Label this figure by completing the empty boxes so it depicts the Solow growth model. Use the
following notation: k, y, s, f(k) (production function), n (population growth rate) and δ (depreciation
rate). [6]

y
f(k)

y**
δ+n
y*
δ+n’

sf(k)

k
k* k**

b. Label the equilibrium (k, y) as (k*, y*). [2]

c. Suppose that n decreases. [6]

(i) Augment the figure above as needed to reflect this change.

(ii) Label the new equilibrium as (k**, y**).

(iii) Provide a brief intuitive explanation for why a decrease in n changes the equilibrium in this way.

The decrease in n, population, means a decrease in the number of workers. This means there is more
capital for each worker, that is, k increases. So the capital is more productive, and output increases.

5. IMPACT EVALUATION. Ozzy is the mayor of Lima, Peru. She is concerned that violent crime
is reducing income levels in her city. To address this problem, Ozzy created a Neighborhood
Watch program that increases the number of policewomen patrolling the streets. Before expanding
the program to the entire city, Ozzy first implemented a pilot version of the program in the
neighborhoods in Lima with the highest crime rates. She then hired BEN, a famous theoretical
economist, to estimate the causal impact of the Neighborhood Watch program on household
income.

Ben took a random sample of 1,000 households from the neighborhoods that received the
Neighborhood Watch program and another random sample of 1,000 households from
neighborhoods that did not receive the Neighborhood Watch program. In Ben’s final report to
Ozzy, he estimates the Average Treatment Effect of the program by subtracting the average income
of the 1,000 households in neighborhoods that did not receive the program from the average
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income of the 1,000 households in neighborhoods that did receive the program.

a. Write a definition of Selection Bias. Break your definition into the following three parts:
i. An equation that defines Selection Bias using notation from the Potential Outcome
Framework that we developed in class.

Selection bias is equal to: . (Also acceptable to

write True Average Treatment Effect – Naïve Average Treatment Effect).

ii. A sentence that defines the two main terms in your equation.

is the expected value (the average) of the outcome variable

without treatment for the treatment group. Or it’s what the treatment group
would have earned if they had not been treated. In terms of our example, it is
the average income that households in neighborhood watch neighborhoods
would have earned if they had not received the neighborhood watch program.
This is a counterfactual object.

is the expected value (the average) of the outcome variable

without treatment for the control group. It’s just average earnings of the
control group, which in our example are the households that lived in the
neighborhoods that received the Community Watch program. This is an
observable/measurable object.

iii. A brief explanation of when selection bias would exist (i.e., when it would not be
equal to zero).

Selection bias exists if . This would occur if there

are systematic differences in the control and treatment groups so that the
control group does not give us a good estimate of what the treatment group
would have earned if they had not been treated.

b. Without any further information, do you expect that Ben’s estimate of the Average Treatment
Effect will have zero selection bias, negative selection bias or positive selection bias?
Explain your answer.

The Neighborhood Watch Program was implemented only in the neighborhoods that had the
highest crime levels. We might expect that these are these are the poorest neighborhoods (or
even the richest neighborhoods where people have more things to steal!). In either case,
average income without the program would be different in the treatment neighborhoods than
in the control neighborhoods (which were not the highest crime neighborhoods). Therefore,
we would expect a non-zero selection bias.

For the rest of this question, use the Table 1 below. Some of the numbers come from Ben’s
findings. The other numbers are counterfactual numbers (assume we can conduct Parallel Universe
surveys).

Table 1
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 $10,000 $3,000
$11,000 $5,000

c. Which of the two numbers in Table 1 come from (i.e., can be measured by) Ben’s research?

10,000 & 5,000.

d. According to Ben’s research, how large is the impact of the Neighborhood Watch program on
household income? (i.e., what is Ben’s estimate of the Average Treatment Effect?)

The Naïve Average Treatment Effect = = 5,000 – 10,000 = -

5,000.

e. How large is the selection bias in Ben’s findings from Part d? (Make sure you provide a
number and, if that number is not zero, make sure you indicate if it is positive or negative.)

= 3,000 – 10,000 = -7,000

f. What is the true causal impact of the Neighborhood Watch program on household income?
(i.e., what is the true Average Treatment Effect?)

The True Average Treatment effect is equal to:

.