Exam 2020, 1st attempt Solutions

Notice: Any kind of reproduction and publication of this sample solution and/or
the exam is strictly forbidden. You may take notes and copies for your own
personal usage only!

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

Question 1 (16 Points)

(a) The Payoff Matrix below depicts the payoffs of two countries A and B that can both choose
between participating in an international agreement and not participating.

(Payoff A ; Payoff B) Participating Not Participating

Participating (2 ; 2) (1 ; 4)

Not Participating (4 ; -3) (-1 ; -2)

i) What is/are the Nash-Equilibrium/-Equilibria in pure strategies? (2 Points)

Answer:
The only Nash-Equilibrium in pure strategies is (Participating; Not Participating) [If in ad-
dition to this answer other strategy combinations were named, points were sub-
tracted]
ii) Which situation/s is/are Pareto efficient? (2 Points)
Answer:
There are three Pareto efficient situations:
(Participating; Participating); (Participating; Not Participating); (Not Participating; Partici-
pating) [Full points only if all three were named]

(c) Briefly explain the ”Big-Push”-Approach by Rosenstein-Rodan (1943). (4 Points)

Answer:

– Main assumption: Firms invest in an industry if they expect the demand to be sufficiently
high → a certain threshold of demand must be reached [1 P]
– However, demand also depends on the investment made by firms, as these investments
create jobs and income → Reverse relationship between the two variables. Only if invest-
ment is high enough, demand is sufficient. Too little demand causes too little investment,
which causes too little demand etc. [1 P]
– Investment of a single firms therefore has positive externalities (underinvestment may be
the consequence) [1 P]
– The Big Push refers to the idea that a huge (external) investment, e.g. made by a foreign
investor or in the form of foreign aid, may push the demand above the critical threshold
and hence attract further investments. It helps to move from a bad to a good equilibrium
[1 P]

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

(d) Briefly explain the concept of ”Purchasing Power Parity” and why it is relevant for the com-
parison of income levels in different countries. (4 Points)
Answer:

– The concept of the PPP converts monetary variables (e.g. GDP) using a hypothetical
exchange rate to make it comparable between different countries. The hypothetical ex-
change rate accounts for different price levels and therefore different purchasing powers in
different countries. [2 P]
– Price levels differ between countries due to, among other factors, different wages caused
by different productivities. The productivity and hence the price level in less developed
countries is usually lower than in developed countries. [1 P]
– Without the PPP adjustment, income differences between developed and less developed
countries tend to be overestimated and hence inequality will be. [1 P]

(e) Briefly explain the ”Environmental Kuznets Curve”-Hypothesis and the underlying assump-
tions. (4 Points)
Answer:

– The EKC-Hypothesis refers to the empirical observation that there may exist an inverted
U-shape relationship between income and environmental degradation on a country level
[1 P]
– It is assumed that pollution first increases once a country industrializes starting from an
agricultural focus (income increases during this process), as industrial activity is usually
more polluting than agriculture. [1 P]
– At the stage of an industrialized economy, a country usually uses strongly polluting tech-
nologies and the environmental awareness of the people is not yet distinct. [1 P]
– Once the country develops further, it moves towards a service oriented economy, which
is less polluting than classical industries. Moreover, as income increases further, environ-
mental awareness of the people usually increases. [1 P]

Question 2 (19 Points)

Consider a country that ”consumes” the two goods income (Y ) and air quality (A). The aggregate
production function is given by Y = 100 + 2P , where P , the level of air pollution, is a by-product of
production. The air quality depends on P according to A = 200 − 2P .

(a) Assume that the aggregate preferences of the country can be described by U = Y 0.5 A0.5 .
Determine analytically the optimal levels of A and Y . (7 Points)
Answer:
A = 200 − 2P ⇔ P = 100 − 0.5P
Y = 100 + 2(100 − 0.5A) = 300 − A [1 Point] (Production Possibilities Frontier)
max U = (300 − A)0.5 A0.5 [2 Points]
∂U
∂A
= −0.5(300 − A)−0.5 + (300 − A)0.5 · 0.5A−0.5 = 0

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

⇔ 0.5A0.5 (300 − A)−0.5 = 0.5A−0.5 (300 − A)0.5 [1 Point]

0.5A0.5 (300−A)0.5
⇔ 0.5A −0.5 = (300−A)−0.5

⇔ A = 300 − A
⇔ A∗ = 150 [2 Points] → P ∗ = 25 → Y ∗ = 150 [1 Point]

(b) Graphically depict the production possibilities frontier (PPF) of the country in the box on the
next page. (6 Points)
Remarks about common mistakes that were made:

– Wrong axis intercepts and/or wrong slope

– Non-Linear PPFs (this is completely wrong here according to the given functions)
– There is no part of the PPF below Y = 100 (see the production function), so the function
is not defined for this area.

(c) Add an indifference curve to your graph and graphically depict the optimal consumption bundle
calculated in (a). (2 Points)
Remarks about common mistakes that were made:

– IDCs are never increasing, so it is not correct to draw a curve that increases again after
a minimum
– The IDC for a Cobb-Douglas utility is non-linear, i.e. degressivly decreasing. It is not
linear.
– If the tangent point was not depicted at the point (150; 150) as calculated in (a), points
were subtracted

(d) Consider now the introduction of a green technology that changes the aggregate production
function to Y = 150 + 3P . Depict the effects on equilibrium income and air quality in your
graph. (4 Points)
Remarks about common mistakes that were made:

– The new PPF has shifted upwards and is steeper than the original one
– It ends at point (200, 150), the minimum Y is 150 and the maximum A is 200
– It was not necessary to exactly find the new tangent point, but it nevertheless had to be
depicted on the new PPF

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

Y 6
450
J
J
J
J
J
J
400 J
J
J
J P P F (d)
J
J
J
J
J
J
J
J
J
J
J
300 J
@
@ J
@ P P F (a&b) J
@ J
@ J
@ J
@ J
@ J
@ J
J 0
J·C
@
@
··J
@ ·· J
@ ·· J
200
@ ·· J
@ ··
·· J
··
@
J
@ ··
··
@ J
· J
@ ···
@
J
@ ·· C J
150 ···································································
·· J·
··
@
·· @ IDC
·· @ ··
·· ··
·· ··
··
@
·· @ ·
·· @ ··
·· ·
100 · @ @··
·· ·· IDC
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
·· ··
· · -
0 100 150 200 300 A

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

Question 3 (10 Points)

Consider the Solow Model with the production function Y (t) = 4K(t)1/2 L(t)1/2 . The depreciation
8
rate is δ = 5%, the savings rate is s = 12.5%, and the population growth rate is given as n = y(t)2.
ss
Derive analytically the steady state level of the per capita capital stock k and of the per capita
income y ss .

Solution:
Y (t) = 4K(t)1/2 L(t)1/2 ⇔ y(t) = 4k 0.5
8
k̇ = s · y(t) − k(δ + n) [1 Point] = 0.125 · 4k 0.5 − k(0.05 + (4k0.5 )2
) [1 Point]
k̇ −0.5 1
k̂ =k
=0.5k − 0.05 − = 02k
| · 2k [2 Points]
0.5
⇔ k − 0.1k − 1 = 0 | · −10 and set k 0.5 = x [2 Points]
⇔ x2 − 10x + 10 = 0
⇔ x1 = 8.87 x2 = 1.13 → k1 = 78.68 [1 Point] k2 = 1.28 [1 Point]
→ y1 = 35.48 [1 Point] y2 = 4.53 [1 Point]

Question 4 (15 Points)

Column 1 in table 1 below shows the results of a panel regression of the form

Inequalityit = αi + β1 · GDPpcit + β2 · (GDPpc)2it + it ,

where GDP per capita is measured in thousand inflation adjusted U.S. dollars, (GDPpc)2 is GDP per
capita squared, and i and t are the country and the time indices, respectively. In the specification of
the second column, the variables T ourists, which measures the number of incoming tourists relative
to the domestic population, and Democracy as well as an interaction term between the two are
added. Democracy is an index that ranges from -10 to +10, with higher values indicating more
democracy. The dependent variable in both regression specifications is the ratio of the top to the
bottom quintile of the income distribution.

(a) Interpret the relationship between income (GDP per capita) and inequality depicted by the
results (Only focus on column 1 for this). Link your interpretation to what we discussed in
this course regarding the mentioned relationship. Is the relationship suggested by the results
in line with what you expect? Explain! (7 Points)
Hint: The regressions in both specifications use a within-estimator, i.e. a regression
technique that takes into account only changes within countries over time, but not
differences between countries.
Answer: Note: This is just one potential way how to answer the question. However,
the main points mentioned here were necessary to obtain full points.
The partial effect of GDP per capita on inequality depicted by the results is expressed as the
first derivative of the regression equation with respect to GDP per capita, i.e. ∂Inequality
∂GDPpc
=
β1 + 2 · β2 GDPpc. Hence, the coefficients β1 and β2 can no longer be interpreted separately to
get the total effect of income on inequality in this specification. Given the estimated coefficients

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

Table 1: Regression results

Income ratio Income ratio

Real GDP per capita −0.25∗∗ −0.235∗∗

Real GDP per capita2 0.005∗∗∗ 0.005∗∗∗

Tourists 2.401∗∗∗

Democracy 0.084

Tourists ∗ Democracy −0.22∗∗

R2 0.20 0.23
No. of Countries 152 138
No. of observations 1,237 1,148
Time period covered 1996-2017 1996-2017
Own estimations based on data from The World Bank.
Time and country fixed effects are included in both specifications.
∗∗
and ∗∗∗ denote significance at the 5% and 1% level, respectively.
The output shown here is reduced to the elements relevant for the purpose of this exam.

in column 1, the partial effect of GDPpc on inequality is depicted by ∂Inequality

∂GDPpc
= −0.25 + 0.01 ·
GDPpc and thus follows a U-shape relationship. The turning point of the parabola lies at 25.000
U.S. dollars (set the first derivative equal to zero), which suggests that during the development
process, inequality in a country first declines and after the threshold of a GDP per capita of
25.000 U.S. dollars increases again. This result is contrary to the empirical observation of the
Kuznets curve, which describes an inverted U-shape relationship.

(b) Briefly explain the idea behind adding the variables T ourism, Democracy and their interaction
to the specification in column 2. Give a short interpretation of the possible relationship between
tourism and inequality and the role of democracy in this context as indicated by the results in
column 2. (8 Points)
Answer:
Note: This is just one potential way how to answer the question. However, the
main points mentioned here were necessary to obtain full points.
First of all, the added variables can be seen as control variables. The number of tourists may
serve as a proxy for the economic (and maybe also cultural) openness of a country. Democracy
is an important factor to take into consideration when trying to explain inequality, as more
democratic societies may redistribute more due to the broader political participation among
the people.
Moreover, we can also directly interpret the estimated relationship between tourism and in-
equality. Again, the partial effect is the partial derivative of the regression equation with
respect to the variable of interest, i.e. ∂Inequality
∂Tourists
= 2.401 − 0.22 · Democracy. This suggests that

Prof. Dr. Oliver Lorz

Exam 2020, 1st attempt Solutions

the partial effect of tourism on inequality depends on the level of democracy (interaction effect,
both coefficients are significant). Plugging in low levels of democracy (e.g. the minimum of -10)
yields a stronger partial effect of tourists in inequality (e.g. ∂Inequality


∂Tourists
|Democracy = −10 =
2.401 − 0.22 · (−10) = 4.601) compared to high levels of democracy (e.g. the maximum of +10,
which yields ∂Inequality


∂Tourists
|Democracy = 10 = 2.401 − 0.22 · (10) = 0.201), which indicates that
strong democratic institutions mitigate the effect of tourism on inequality.
One possible explanation might be that in less democratic countries, only a small elite of the
people really benefits from tourism if this elites owns the hotels and other relevant resources
for tourism. Under weak institutions, the broad working class may may benefit less (if at all),
if labor rights are weak, burdens for entrepreneurship high and real wages low.

Prof. Dr. Oliver Lorz