Development Economics at ICEF

Midterm exam
March 22, 2019

Part II: Problems.

Marking Scheme
16. (25 pts) Consider an economy with three individuals, whose incomes are x, 1, and 10. Find
the value of x such that the Gini coefficient is 0.5.

x=1 if x<=1 or x=37 if x>10.

Approximate marking within different cases:

3 points max for correctly outlining the approach to the solution (calculating cumulative shares of
income)
12 points max for arriving at the result with correct approach but having serious mistakes within the
solution (e.g., wrong approach to area calculation; arriving at x>1, while placing a person with x first;
fundamental math mistakes (not miscalculations), etc)
25 points max for correctly arriving at the result (at least one (x=1 or x=37) given the assumption on x
size is stated explicitly in the beginning)

17. Consider a migrant who works abroad for fraction x of his life, and then returns home for
retirement for the remaining time 1-x. The wage abroad is w. The worker derives utility from
lifetime earnings c=wx and from retirement duration, as follows: u=c1/2+(1-x)1/2.
a. (15 pts) How does an increase in foreign wage w affect the duration of foreign stay x?

To get the equilibrium, solve the UMP. Person chooses x (duration of stay), thus, find u -> max (x).
Solution is x=w/(1+w). Thus, increase in w increases x (duration of stay).
+5 points for correctly stating the UMP and FOC
+5 points for deriving x(w)=w/(1+w)
+5 points for arriving at the conclusion on the effect of changes in w (either by taking a derivative of x(w)
by w or using other analytical explanation. An increase in w increases x (duration of stay))

b. (10 pts) Same question if utility was u=min(c,1-x).

To get the equilibrium wx=1-x => x=1/(1+w). Thus, increase in w decreases x (duration of stay).
+2 points for explaining why wx=1-x is an equilibrium (wx>1-x and wx<1-x could be considered)
+8 points for deriving x(w) and arriving at the conclusion on the effect of changes in w (there’s no SE =>
by IE increase in w decreases x)

c. (15 pts) What is the empirical evidence on how a change in foreign wage w affects
duration of stay x?

5 points for explaining income effect (speed of money accumulation)

5 points for explaining substitution effect (attractiveness of the opportunity)
5 points for stating that empirically SE dominates over IE (Yang study with relevant details can be used)
True, false, uncertain? Provide comments on any one of the following statements. (25 pts.)

18. There is correlation but no causal relationship between inequality and growth.

False/uncertain.
+ 10 points for outlining the correlation (empirical relationship) either through detailed explanation of
Kuznet’s inverted U hypothesis (~ 5 points max) or Person-Tabellini empirics (regressions on 9 countries,
~ 10 points if stated alone, 5 points & less details required if stated with Kuznet’s inverted U)
+ 5 points for explaining the problem of reverse causality (endogeneity) in P-T Empirics as well as
remedy to it (IV, which IV was used & why is it valid)
+ 10 points for explaining theoretical model of P-T in plain words (optimal tax rate for economic growth
vs optimal tax rate for politicians in an economy with inequality. Explanation need to include necessary
concepts such as the median voter theorem, redistribution, etc).
NB: regression (empirics) gives only correlation, not cause-and-effect relationship. To argue about
causality we need to explain theory/model

19. Emigration of high-skilled workers hurts their home country.

Uncertain.
+ 10 points for outlining negative aspects of migration (Early literature or Miyagiwa’s Brain-drain model.
No formal model required but the explanation of Miyagiwa’s model should include explanation of
agglomeration effect)
+ 3 points for outlining 4 key positive aspects of migration (remittances, return migration, diasporas &
incentive effects)
+ 12 points for explaining the details of at least 2 (~6 points each) of the concepts/theories on positive
aspects of migration discussed in class (e.g., motivation/Empiricus on remmitances, positive aspects of
return migration, effects of diasporas on international trade (specific goods) & innovations, Stark &
Wang model of incentive effects & Chand & Clemens support of it on Fiji-New Zealand migration)

Essays – provide a detailed answer to any one of the following questions. (40 pts.)

20. In a ½ page essay, explain how the adverse selection and the moral hazard may be
manifested in the market of voluntary automobile insurance “kasko”.

5 points for writing anything relevant on topic, then:

+ 5 points for defining key characteristics of asymmetric information, adverse selection (AS) & moral
hazard (MH) and/or clearly stating that the AS
+ 11 points for explaining why AS might occur on voluntary car insurance market
+ 11 points for explaining why MH might occur on voluntary car insurance market
+ 8 points for explaining the consequences of AS for the market (increase in the risk profile -> increase in
the premium price -> lower risk drivers exit the market), consequences of MH (lower expected profits
for insurance company -> higher premiums/lower coverage) & potential solution (AS: signaling,
advanced pricing mechanisms & MH: risk sharing). NB: monitoring is an unlikely solution for voluntary
insurance market

21. Outline the implications of Kremer’s O-ring theory that are consistent with empirical
observations.

5 points for writing anything relevant on topic, then:

+ 6 points for introducing the idea of O-ring model, its goals and approaches
+ 20 points for outlining 9 key implications of the O-ring theory (approx. 2 points each)
+9 points for identifying the empirical consistency of the implications, which are empirically
relevant and which are not (no point reductions if this part is evident from the list of the main
results)