Sample Solutions: Exam Development Economics“

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Summer Term 2021, 2. Attempt, 14.09.2021

Question 1 (22 Points)

(a) The payoff matrix below depicts the payoffs of two firms A and B that can both choose between
investing in an developing country and not investing.

(Payoff A ; Payoff B) Not Investing Investing

Not Investing (99 ; 98) (101 ; 97)

Investing (98 ; 102) (100.5 ; 101.5)

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

Answer:
The only Nash-Equilibrium in pure strategies is: (Not Investing; Not Investing).
[2 points for correct answer, 0 if any wrong or additional is named.]
ii) Which situation/s is/are Pareto efficient? (2 Points)
Answer:
Three Pareto efficient situations: (Not Investing; Investing), (Investing; Not Investing), (Investing;
Investing)
[2 points if all three are named, otherwise 0.5 per correct and -0.5 per incorrect.]

(b) Briefly explain two channels through which the degree of democracy may affect economic development
of a country. Briefly explain why it is challenging to identify the causal effect of democracy on
economic development empirically. (8 Points)
Answer:
The following aspects are examples for how the answer may look [2 points for each correctly
explained channel]

– Democracy may enhance property rights, which are an important driver of investments, patents,
innovations and hence economic development
– Democracy may promote secure legal systems, which are important for economic development
for similar reasons as it is the case with property rights
– Democracies usually exhibit higher levels of education due to higher public spending on educa-
tion, as ppl. often vote for a certain level of redistribution
– A higher level of provision with public goods may serve as a complement for private investments
→ higher private investment → economic development
– Democracies often exhibit higher levels of redistribution and thus lower levels of inequality. A
more equal distribution of wealth may enhance investments, if the middle-class exhibits a higher
marginal investment propensity compared to the richest part of the society

Reasons why identifying the causal mechanisms is difficult: [2 points for each correct reason]

– There are two main empirical challenges

– Potential Reverse causality: The causal effect may run in both directions, as economic develop-
ment may also foster democratic structures
– Omitted variables in regressions that affect both economic development and democratic struc-
tures (for example natural resource wealth)

Prof. Dr. Oliver Lorz 1/5

 (c) Consider an income distribution, where the deciles hold the following income shares:

1 2 3 4 5 6 7 8 9 10
1.5 1.8 3.1 5.9 a 11.2 12.7 14.9 17.6 b

Assume that the Palma ratio is 2.

(a) Calculate the missing values a and b. (3 Points)

Answer:
b
Palma ratio = 2 = (1.5+1.8+3.1+5.9) ⇔ b = 2 · 12.3 = 24.6 [1 point for equation, 1 point for
correct value of b]

a = 100 − (1.5 + 1.8 + ... + 24.6) = 6.7 [1 point]

(b) Calculate the median/bottom quintile ratio. (2 Points)
Median/bottom quintile: 6.7+11.2
1.5+1.8
≈ 5.42 [1 point for equation, 1 point for correct result]

(d) Efforts by individual countries to reduce greenhouse gas emissions can be interpreted as a public
good in an international perspective. Explain why this may be the case and briefly discuss why
developed countries may have an incentive to financially support less developed countries to invest
in greenhouse gas reductions. (5 Points)
Answer:
The following aspects are examples for how the answer may look [2 points for each correctly
explained channel]

– Reducing greenhouse gas emissions benefits also ppl. in other countries (even worldwide), as
climate change is a global issue
– There is nor rivalry in enjoying a good climate
– Nobody can be excluded from the benefits of climate protection
→ Potential free-rider problem: Countries which do not invest in these reductions still benefit
from efforts made by others
– Financial support for less developed countries also benefits ppl. in the developed countries, for
mentioned reasons
– Financial support may help to overcome the underinvestment problem in developing countries
– However, if the capital that flows from developed to developing countries for climate protection
investments is more productive in the developed ones (due to complementarity for example), it
may be reasonable to invest it there

Prof. Dr. Oliver Lorz 2/5

Question 2 (10 Points)

Consider a growth model with the production function Y (t) = 2K(t)0.4 L(t)0.6 . The depreciation rate
is δ = 4 %, the savings rate is s = 8 %, and the population growth rate is given as n(t) = y(t)−3 , with
y(t) = Y (t)/L(t). Derive analytically the steady state level of the per capita capital stock k ss and of the
per capita income y ss .
Answer:

K
y(t) = 2k 0.4 with k =
L
k̇ = s · y(t) − k(δ + n) [1 point] = 0.08 · 2k 0.4 − k[0.04 + (2k 0.4 )−3 ] [1 point]
k̇
k̂ = = 0.16k −0.6 − 0.04 − 0.125k −1.2 = 0 | · k 1.2 [1 point]
k
⇔ 0.16k 0.6 − 0.04k 1.2 − 0.125 = 0 | : (−0.04) [1 point]
1.2 0.6 0.6
⇔ k − 4k + 3.125 = 0 | set k = x [2 point]
⇔ x1 ≈ 2.94 x2 ≈ 1.06 → k1 ≈ 6.03 [1 point] x2 ≈ 1.10 [1 point]
⇒ y1 ≈ 4.10 [1 point] y2 ≈ 2.08 [1 point]

Question 3 (14 Points)

Consider a small closed economy (home) with the production function Y = L0.5 · S 0.5 · K 0.5 , where Y
is aggregate output, L is unskilled labor, S is skilled labor, and K is capital.

(a) Derive analytically the wage rate of the unskilled workers ωL as a function of the skilled-unskilled
labor ratio s = LS and of the capital stock. (5 Points)
Answer:

ωL = M P L [1 point]
∂Y
⇔ ωL = [1 point]
∂L
⇔ ωL = 0.5L−0.5 S 0.5 K 0.5 [1 point]
⇔ ωL = 0.5s0.5 K 0.5 [2 points]
∂ωL
with >0
∂s

(b) Consider a second country (foreign) with the same production function. The foreign country has
the same skilled-unskilled labor ratio as the home country in the initial situation, i.e. s∗ = s, but
a smaller capital stock, i.e. K ∗ < K. Suppose the two countries now open up for migration of high
skilled workers (assume that there are no migration barriers). Unskilled workers and capital remain
immobile between countries. Which kind of migration pattern do you expect and why? Explain
the underlying mechanism and the consequences for wages of skilled and unskilled workers in both
countries. (9 Points)

Prof. Dr. Oliver Lorz 3/5

 Answer:
To determine the migration pattern of the skilled workers, the wage rates of the skilled workers need
to be compared. The wage rate of the skilled worker.

∂Y 0.5K 0.5
ωS = M P S = = 0.5L0.5 S −0.5 K 0.5 = √
∂S s

With s∗ = s and K ∗ < K, foreign has a lower wage rate for skilled workers, i.e. ωS∗ < ωS .
[3 points]
This leads to the following mechanisms:

– Skilled workers migrate from foreign to home [1 points]

– The wage rate of skilled workers declines in home [1 points]
– The wage rate of the skilled workers increases in foreign [1 points]
– Migration of skilled workers stops when wages of skilled workers equalize in both countries,
ωS = ωS∗ [1 points]
– The wage of unskilled workers declines in foreign [1 points]
– The wage of unskilled workers increases in home [1 points]

Question 4 (14 Points)

Consider a developing economy that ”consumes” the two goods income (Y ) and primary forests (F ). The
aggregate production function is given by Y = 0.5D2 , where D is the level of deforestation of the primary
forest. The size of the primary forest depends on the level of deforestation and is given by F = 100 − D2 ,
with 100 being the total initial stock of the primary forest.

(a) Graphically depict the production possibilities frontier (PPF) in a two-sector-diagram, add an indif-
ference curve and depict the optimal consumption bundle. (8 Points)
Answer:
Derive the PPF:
√
Y = 0.5D2 , with F = 100 − D2 ⇔ D = 100 − F
√
⇒ Y = 0.5( 100 − F )2 ⇔ Y = 50 − 0.5F

(b) Assume that a huge wildfire destroys 19 % of the initial stock of the primary forest. Graphically
depict in your graph for (b) how this changes the optimal consumption bundle if primary forest is
an inferior good. (6 Points)
Answer:
Now, the size of F has declined to 81 (= 100 · (1 − 0.19)), the maximum level of deforestation to
Dmax = 9, and hence Y max has declined to 40.5.
As forest is considered an inferior good here, the consumed quantity of forest increases in the new
situation with lower overall consumption possibilities (decline in income). Thus, the new consumption
point C 0 must lie to the right of the initial one C (if F is depicted in the horizontal axis).

Graph on next page:

Prof. Dr. Oliver Lorz 4/5

 The following aspects of the graph are rewarded:

• The PPF is linear with the intersections F max = 100 and Y max = 50

• The indifference curve is strictly decreasing and convex

• In (b), the intersections change to F1max = 81 and Y1max = 40.5, hence the PPF shifts inwards (and
rotates for the presented scale)

• The new consumption point C 0 lies on a lower indifference curve and to the right of the initial
consumption point C (if F is depicted on the horizontal axis)

50
@
@
40.5 @ P P F (a)
@
@
@
@
@
@
@
@
@
P P F (b) @
@ C
25 @
@
@
@
C 0 @ IDC
@
@
@
@
@
@
@
@
@
@ -
0 50 81 100 F

Prof. Dr. Oliver Lorz 5/5