Sample Questions for End-Sem 2024

1. Reallocation can occur if less productive firms exit or more productive firms enter.
Which of the following factors will improve reallocation
a. Free Trade Agreement
b. Education subsidies
c. R&D rebates
d. No Compete Agreements, wherein firms make their workers sign contract
which disallows them from working with a competitor for a pre-specified
duration.
e. Training Cost Reversal, wherein firms make their workers sign contract which
forces the workers to refund the firm amount that was spent in training them.

𝛽
2. Imagine that the production function is 𝑌𝑖 = 𝐴𝑖 𝐾𝑖𝛼 𝐿𝑖 and the costs are given by 𝑤. 𝐿𝑖 +
𝑅. 𝐾𝑖 . 𝐴𝑖 takes two values—5 and 10.
a. Compute the decline in the aggregate output in the short run and long run if a
5% wage tax is imposed on factories.
b. Taxes and death are certain. If the government has to impose a tax but the
government is also concerned with total output, which factories should be
taxed—more productive or less productive one.

𝛽
3. Let the production function be 𝑌𝑖𝑡 = 𝐴𝑖𝑡 𝐾𝑖𝑡𝛼 𝐿𝑖𝑡 . With logarithmic transformation, we
write 𝑦𝑖𝑡 = 𝑎𝑖𝑡 + 𝛼𝑘𝑖𝑡 + 𝛽𝑙𝑖𝑡 . Find the production function estimation equation
under the following productivity evolution process
a. 𝑎𝑖𝑡 = 𝑎𝑖𝑡−1 + 𝜀𝑖𝑡
Solution: The trick in many of these structural econometrics problem is to somehow
replace an unobservable object with observable data. This replacement should be
such that the observable data is a good proxy for the unobservable object.
Since 𝑦𝑖𝑡 = 𝑎𝑖𝑡 + 𝛼𝑘𝑖𝑡 + 𝛽𝑙𝑖𝑡 , we can write
𝑎𝑖𝑡 = 𝑦𝑖𝑡 − 𝛼𝑘𝑖𝑡 − 𝛽𝑙𝑖𝑡 .
But then
𝑎𝑖𝑡−1 = 𝑦𝑖𝑡−1 − 𝛼𝑘𝑖𝑡−1 − 𝛽𝑙𝑖𝑡−1 .
We can insert the above two equation in the productivity evolution process to write
𝑦𝑖𝑡 − 𝛼𝑘𝑖𝑡 − 𝛽𝑙𝑖𝑡 = 𝑦𝑖𝑡−1 − 𝛼𝑘𝑖𝑡−1 − 𝛽𝑙𝑖𝑡−1 + 𝜀𝑖𝑡
𝑦𝑖𝑡 − 𝑦𝑖𝑡−1 = 𝛼(𝑘𝑖𝑡 − 𝑘𝑖𝑡−1 ) − 𝛽(𝑙𝑖𝑡 − 𝑙𝑖𝑡−1 ) + 𝜀𝑖𝑡
Now, we have replaced the unobservable object with observable data. We can
now estimate this equation. This is known as the First Difference Regression.
 𝑎𝑖𝑡−1
b. 𝑎𝑖𝑡 is a random draw from a uniform distribution between and 1.5𝑎𝑖𝑡−1 .
2
Hint: If x is uniformly distributed between a and b; i.e. 𝑥 ~ 𝑈(𝑎, 𝑏), then
𝑎+𝑏
expected value of x, 𝐸(𝑥) = 2

𝑎𝑖𝑡−1
Solution: Since 𝑎𝑖𝑡 ~ 𝑈( , 1.5𝑎𝑖𝑡−1 ), we can write
2
0.5 𝑎𝑖𝑡−1 + 1.5 𝑎𝑖𝑡−1
𝐸(𝑎𝑖𝑡 ) = = 𝑎𝑖𝑡−1
2

So, the expected value of today’s productivity is the same as last year. But we know
the true value can differ from the expected value because it is a random draw. So
we can write
𝑎𝑖𝑡 − 𝐸(𝑎𝑖𝑡 ) = 𝜀𝑖𝑡

Where, 𝜀𝑖𝑡 is an i.i.d. term. But now we can write

𝑎𝑖𝑡 − 𝑎𝑖𝑡−1 = 𝜀𝑖𝑡
𝑎𝑖𝑡 = 𝑎𝑖𝑡−1 + 𝜀𝑖𝑡

But now this is the same as the previous question.

4. Consider the following production function for a firm 𝑌𝑖 = 𝐴𝑖 √𝑘, where a firm uses
only capital for production. The costs to the firm are 𝑇𝐶 = 𝑟. 𝑘.
a. Compute the profit maximizing 𝑘 and profit for a firm with productivity 𝐴𝑖 .
Denote the optimal profits by 𝑘 ∗ and 𝜋 ∗ .
b. Government wants resources, 𝑘, from less productive firms to move to high
productivity firms. To do so, government introduces a new reform whereby a
firm can trade its resources if it decides to shut down. An example could be the
government reforming the land market whereby buying and selling land
becomes easier. Specifically, a firm can continue operating and earn profits, 𝜋 ∗ ,
OR it can decide to shut down and sell its resources, 𝑘 ∗ , at a scrap value of 𝑣𝑆 =
√𝑘 ∗ . Can you find the maximum value of 𝐴𝑖 such that all firms below this
productivity level would want to shut down and sell its capital for scrap value?
c. Assume that 𝐴𝑖 takes one of these five values—0.5, 1.5, 2.5, 3.5, 4.5. From your
answer in b, which factories will decide to exit? How much capital will they
release back into the market?
d. Reallocation requires not only that the less productive firms exit but that more
productive firms can use these resources. But the latter will happen only if the
price of the resource, 𝑟, falls. Imagine that the resource obtained from the
1
exiting firms can be sold back to the remaining firms at a new price, 𝑟 ′ = ,
∑𝑖 √𝑘𝑖∗

where 𝑘𝑖∗ is the additional resources that an exiting firm i has sold in the market.
For eg; imagine three firms sell their resources in the scrap market. Denote their
1
resource values by 𝑘1 , 𝑘2 and 𝑘3 . The new interest rate will be .
√𝑘1 + √𝑘2 +√𝑘3
Given your answers above, will this new reform lead to any reallocation at all.
 e. Now imagine that the government can improve the efficiency of scrap market;
i.e. the scrap value function changes to scrap value of 𝑣𝑆 = 𝛿√𝑘 ∗ . What should
be the minimum value of 𝛿 such that 𝑟 ′ ≠ 𝑟.

5. Consider a market which has a monopolist wholesaler and two retailers which are
Cournot competitors. The wholesaler sells the product at per unit price of W. Retailers’
only costs is procurement costs. Retailer 1 incurs a procurement cost of W.𝑄2 , whereas
Retailer 2 signed a long term contract with the wholesaler under which its procurement
𝑊
costs are 2 𝑄2. The inverse demand function for retailers is 𝑃 = 25 − 𝑄1 − 𝑄2 .
f. Formulate the objective functions of the retailers and the wholesaler. Note that
the procurement costs for retailers is equal to the price received by the
wholesaler.
g. Find the profit maximizing 𝑄1 and 𝑄2 as a function of W. Given 𝑄1 and 𝑄2 , can
you find the inverse demand function faced by the wholesaler.
h. Assume that the wholesaler’s per unit costs of producing the product is 5. Use
the inverse demand function in the wholesale market to find the profit
maximizing W.
i. Using your answer in c, find the profit maximizing 𝑄1 and 𝑄2 .
j. Government brings in a law which prohibits discriminatory contracts between
retailers and wholesalers. Thus, retailer 2’s new costs is W.𝑄2 . Compute the
aggregate market quantity now.
k. You will find that the aggregate market quantity declines due to this law. Yet,
government imposes such laws quite frequently. As a student of IO, how would
you justify such a law.