Solutions Debraj Ray 1

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Solutions debraj ray-1
Introduction to Economics (University of Delhi)
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Sketches of Answers to Problems
Note The answers below are brief and are only designed to give you the basic idea of how
to approach these problems. You will gain a lot more from studying these answers if you
spend some time independently trying to work on the problems.
❈❤❛♣t❡r ✷
(1) A traded good is one that can be bought and sold through the international market,
while a nontraded good cannot. Of course, these are extreme descriptions of reality, and
some goods may be partially but not fully tradable.
Equilibrium exchange rates are determined by the supply of and demand for a coun-
try’s currency. More specifically, the supply of a country’s currency is determined by that
country’s purchases of imports in the world market, and the demand for its currency is de-
termined by the purchases of that country’s exports by the world. The exchange rate acts
to equalize these two (thereby creating trade balance).
Notice that a rich and productive country is likely to have a stronger currency and a
higher income level. The higher income, in turns, pulls up the prices of those nontraded
products within that country. Thus, measured in terms of exchange rate income, a rich
country looks richer than it really is since we are not accounting for the fact that it faces (on
average) higher domestic prices for the nontraded goods. This is why PPP measurements
typically bring down the relative income of a rich country, and pull up the relative income
of a poor country.
(2) The price of a Big Mac is, to a large extent, determined by the prices in competing
restaurants. Therefore, Big Macs will sell for a higher price in richer countries, where non-
traded restaurants are likely to have higher prices. Intuitively, Big Mac prices incorporate,
to some extent - and often to a better extent than exchange rates do - the “true” cost of
living within a country. Thus, using the relative prices of Big Macs to create “exchange
rates” across currencies can often serve as a good approximation of relative PPP income.
(3) The setting up of infrastructure or industrial standards involves a “fixed cost” and a
“variable cost”, while the benefit of a system is often paid off over a long period of time. In the
example of television transmission systems, the fixed cost would be all kinds of interconnected
senders and receivers that broadcast at a particular type and refinement of resolution, while
the variable cost would be individual TV sets purchased by consumers.

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2 Development Economics
The difference between countries starting afresh and those that already have a pre-
existing infrastructure system is that for the latter, upgrading the system would not only
be fiercely challenged by those who had been benefiting from the old system, but would
also incur extra (opportunity) costs from foregoing the benefits that are to come from the
existing system (see Problem 10 in Chapter 5), not to mention the inevitable frictions during
the transition, such as disruption of services and forcing people to adapt to a new system.
Therefore, countries which have already invested in a particular standard may not want
to tear up this standard and start all over again, unless the benefit of adopting the new
technology is great enough to justify the huge cost.
With no such preexisting systems and hence no such concerns, many developing coun-
tries would jump directly to the latest technology: there is no past, no sunk cost, to be borne
in mind. This is why countries which have been early innovators are often saddled with older
systems, and newcomers can leapfrog over them with the newer technology. Television and
telephone systems are only two examples of these. Chapter 5 discusses these considerations
in detail.
(4)(a) Look at footnote 7 on page 17 in the book and make sure you understand the
details. Using this formula, a country growing at 10% per year will double its income in
seven years, while a country growing at 5% will take 14 years to do so. Now try a direct
argument using a calculator. If a country has income x today and is growing at 10%, it will
1
have an income of x(1 + 10 ) next year. If you understand this, you can see that thinking of
this number as the “new x”, income the year after will be scaled up by the same formula.
1 2
This means that income the day after is just x(1 + 10 ) . Plodding on in this vein, we see
1 t
that income after t years is x(1 + 10 ) . Now think of t as an unknown, and we wish to know:
1 t
for what value of t is x(1 + 10 ) equal to 2x? How would you solve this using a calculator?
(4)(b) ??? “shaves an additional percentage point off its population growth rate for the
next 20 years”;not sure what this means...something like growthratet = 0.99t , or growthratet =
n0 − t, or simply growthratenext20years = n0 − 0.01? Also, when asked “how much richer”
are we comparing to the counterfactual outcome (natural population growth), or the initial
condition?
If it were the last case, and we are comparing to the counterfactual outcome, then the
20 −1.0520
country would be 1.061.05 20 ≃ 20.9% richer.
.
(4)(c) Compounding monthly, we get (1 + 0.3)12 = 23.3; hence the equivalent annual
inflation rate would be approximately (23.3−1)×100 = 2230%. (Compare with the without-
compounding case and feel the power of exponential growth!)
(5) A mobility matrix with no mobility should show 100 on its principal diagonal and
zero everywhere else. This means that countries which were at a certain relative category
of world income at the base date would be in the same relative category at the later date.
In contrast, a mobility matrix that exhibits perfect mobility should have equal percentages
along its rows (adding to 100). This means that countries in some relative category at the
base date have an equal chance of being in any relative category at some later date.

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Answer Keys 3
If poor countries grow faster than rich countries, then two things happen: both poor
countries and rich countries would be pushed closer to the world average, the former upward
and the latter downward. This means that the mobility matrix would tend to have its larger
numbers (on each row) closer to the categories that are clustered around world average
income.
You are encouraged to write down specific mobility matrices that capture this notion
of convergence, as well as examples of those that capture divergence.
(6) Using Table 2.1 to construct a Kuznets ratio, I get the following sequence of numbers,
corrected to one decimal place (written in order of ascending income): 2.5, 2.8, 2.0, 2.4, 5.4,
4.6, 1.9, 4.4, 1.7, 3.6, 7.9, 9.3, 4.5, 3.8, 7.5, 5.4, 6.0, 4.2, 5.4, 2.1, 2.2, 2.4, 1.5, 2.0, 2.2, 2.3,
2.9. If income were distributed almost equally, then I would expect that the poorest 40%
would obtain almost 40% of the total income, while the richest 20% would earn a little bit
more than 20% of the total income. The ratio, then, should be around 0.5. This is the index
of perfect equality.
In contrast, note that for the countries in Table 2.1, the ratio attains a low of 1.7 (for
Sri Lanka), and this is significantly above the perfect equality mark. The high (for Brazil)
is a staggering 9.3, which means that the richest 20% of the population earn over nine times
that of the poorest 40%.
In our sample, there is a distinct tendency for the ratio to first rise and then fall.
Whether this is a “law” of development or just an artifact of the observation that most
Latin American countries are middle-income and have high inequality remains to be seen,
however.
(7) Open-ended question. Regarding the last point, it is often a matter of tradeoff: Pre-
senting the indicators separately gives people a full picture of what is happening but can
sometimes seem redundant (since in many of the cases they display the same trend anyway)
and overwhelming; while a single aggregated number abstracts much information away from
reality, it often comes in handy for decision making purposes such as determining a cutoff
rule.
(8) Most famines are caused by local rather than global factors, whether they be political,
climatic, or simply bad luck. Hence, on a global scale, where the per capita availability of
food grain is usually quite stable (if not growing), it is hard to make sense of so many people
suffering from famine when there is adequate food grain.
(9)(a) Open-ended question. It is possible that instead of looking only at the number of
children, parents also care about the quality of their children. A (probably inappropriate)
analogy would be, when you get richer, instead of purchasing two low-end cell phones, you
might want to simply purchase a trendy high-end model.
(9)(b) Higher population growth rates are usually the results of higher rates of newborn
children, who are and will remain under 15 for 15 years. Accumulating overtime, they can
make up a rather large proportion of the overall population.

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(9)(c) Open-ended question. Poorer countries may be more likely to be rural because it
often requires a certain level of trade and productivity (either industrial or agricultural)
to induce urbanization. On the other hand, rural countries face many challenges to grow
rich; for instance, rural areas are usually less densely populated, rendering it harder for the
government to provide education and health services to the local residents.
(9)(d) As we have seen, prices of primary goods typically fluctuates more than those of
manufactured goods. One possible explanation is that primary goods are more susceptible to
factors largely beyond human control (such as rainfall). Manufactured goods are less likely
to experience large price fluctuation since price fluctuations in a few of its inputs can only
affect its price to a certain degree, if not cancelling out each other completely.
❈❤❛♣t❡r ✸
(1)(a) The running costs are for labor ($2000 times 100) and for cotton fabric, which is
$600,000. Thus total costs are $800,000 per year. Total revenues are $1 million. Thus profits,
not counting setup investment, are $200,000 per year.
(1)(b) To figure out income generated, we must count the wage payments to workers as
well, which are $200,000. Thus income generated is wages plus profits (there are no rents
here), which is $400,000 per year.
(1)(c) The output of the firm is $1 million per year. The firm’s installed capital is $4
million. Therefore the capital-output ratio is 4. Notice that the capital equipment can be
used over and over again (though it might depreciate over time). Therefore a capital-output
ratio larger than one is perfectly compatible with the notion of profitability.
(2)(a) δ = 0, hence s/θ = g. When θ = 4, s = 4g, and hence the savings rate should be
0.32 and 0.4 when g = 0.08 and 0.1, respectively. Similarly, when s = 0.2, θ = s/g = 0.2/g,
and therefore θ needs to be 2.5 and 2 when g is 0.08 and 0.1, respectively. A fall in the
capital-output raito means that for every unit of capital the firm can produce more output.
(2)(b) Using the approximation provided by equation (3.7), we see that the growth rate
falls by the same amount as the increase in depreciation rate. When depreciation rate is 3%,
we need s/θ to be 3%+5%=8% to achieve a 5% growth rate. This translates into a savings
rate of 4×8%=32%.
s
−δ−n
(2)(c) Rearranging equation (3.6) we get g ∗ = θ 1+n . Plugging the numbers we get
.
g ∗ = 0.0196 = 1.96%. It is obvious from the expression above that g ∗ = 0 when n = θs −δ=4%
(notice that g ∗ could be negative if population growth is even higher). It makes sense because
g ∗ is a per capita measure, and hence gets smaller as the population grows faster.
(2)(d) Please appreciate the beauty of the equations.

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Answer Keys 5
(3)(a) Neglecting depreciation in this exercise, The Harrod-Domar model leads us to the
equation: g = s/θ, where g is the aggregate growth rate, s is the rate of savings, and θ is
the capital-output ratio. Here s = 1/5 and θ = 4. So g = 1/20, or 5% per year.
(3)(b) Using the approximation provided by equation (3.7), we know that the per capita
growth rate is the aggregate growth rate minus the population growth rate. Therefore, if the
required per capita growth rate is 4% and the population growth rate is 3%, the required
aggregate growth rate is 7%. Then the required rate of savings is g × θ, which in this case
is 0.07 × 4=28% of total income.
(3)(c) Due to the labor strikes, the effective capital-output ratio is now θ∗ = θ × 4/3 =
4 × (4/3) = 16/3. Using this in the Harrod-Domar equation with the rate of savings equal
to 0.2, we see thatg = s/θ∗ = 3/80 = 3.75%. Subtract the population growth rate to get the
per-capita growth rate: 1.75%.
(3)(d) Economic well-being is determined by both current consumption and future con-
sumption. A higher savings rate benefits future consumption at the expense of current
consumption. Hence, the objective should not always be to raise savings rates, but to find
an intermediate rate of savings that balances current and future consumption.
(4)(a) For example, in the first year, the growth rate of the professor’s salary is 1000/100000=1%,
while the rate for the teacher is 1000/50000=2%.
.
(4)(b) It would be $20000 × (1 − 1.5%)200 = $973. Notice that there is a subtle differ-
ence from asking “If growth occurred at 1.5% over the last 200 years and income today
stands at $20,000, what must income have been 200 years ago?”. This variation would yield
.
$20000/(1 + 1.5%)200 = $1018.
(5)(a) Effective labor grows at the rate of labor force growth plus the rate of labor-
augmenting technical progress, so the answer is 5% per year.
(5)(b) At k = 2, total output is y = 1. So the ratio of capital to output is 2. At k = 6,

we have to figure out what total output is. The first three units of k produce y = 1.5 units
of output. The next three produce an additional 3/7 units of output. So total output when
k = 6 is (3/2) + (3/7) = 27/14. The ratio is, therefore, 6 × (14/27), which is approximately
3. Note that this is different from the “marginal” capital-output ratio in this region of the
production function: each additional unit of output is requiring 7 units of capital rather
than 3. The average ratio is less than the marginal ratio, because the former includes capital
applied in the earlier phase of the production function, where its marginal product is higher.
This captures the notion of diminishing returns to capital. Similarly, the capital-output ratio
for k = 12 is approximately 4.4.

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(5)(c) Let’s go through the derivation of the Solow model. New capital is simply old
capital plus extra investment. But savings equals investment, so capital in period t + 1 is
related to what happens in period t by the equation K(t + 1) = K(t) + sY (t), where s is
the savings rate, and Y (t) is income in period t. Now, we divide both sides by the eective
labor force at time t, L(t). Remember that k(t) = K(t)/L(t) and y(t) = Y (t)/L(t) for all t.
So we get K(t + 1)/L(t) = k(t) + sy(t). Notice that the left-hand side is K(t + 1)/L(t) =
[K(t + 1)/L(t + 1)] × [L(t + 1)/L(t)], which is just k(t + 1) × 1.05(L(t + 1)/L(t) = 1.05 from
part (a)). Substitute this back in the equation we get (1.05)k(t + 1) = k(t) + sy(t).
Let θ(t) be the capital-output ratio at date then k(t) = θ(t)y(t). Using this in the
1
formula above, and plugging in s = 1/5, we get (1.05)k(t + 1) = k(t)[1 + 5θ(t) ]. Now we have
a formula that can precisely compute k(t + 1), given any value of k(t)
(5)(d) Using the above equation, and θ(t) derived from the relationship between k(t) and
y(t) given in part(b), we have two series of k’s:
From k(t)=3, we get:3, 3.143, 3.2828,... From k(t)=10,we get:10, 10, 10, 10,...
By a stroke of luck, we have found the steady-state k ∗ =10. You should appreciate the
point that this is just pure luck. What would have happened had you started with k(t) > 10?
(5)(e) We have already found k ∗ =10 by luck in part(d). To solve for it rigorously, notice
that in the long run, k(t) = k(t + 1). Plugging this in to the equation that defines their
relationship, we get θ∗ = 4, which allows us to solve for the unique k ∗ from the production
function in part(b). The solution is indeed k ∗ =10.
(6) Dividing the production function by L(t) on both sides, we get y(t) = Ak(t)α . Plugging
this into equation (3.9) we get (1 + n)k(t + 1) = (1 − δ)k(t) + sAk(t)α . In the steady state,
1
sA 1−α
k(t + 1) = k(t) = k ∗ ; solving for k ∗ from the equation above we get k ∗ = ( n+δ ) . Now
using this equation, you should be able to easily tell the direction in which k ∗ moves, in
response to all the changes asked about in the question.
(7)(a) As discussed in the text, an increase in the savings rate will increase the output
and per capita capital stock in every subsequent period. Using Figure 3.4, we see that the
steady state capital stock per capita must go up as well, so the net effect of an increase in
the savings rate is to push capital and output to a higher long-run level, while leaving the
long-run income growth just as before - equal to the population growth rate. The effect of
depreciation rate is similar. In contrast, higher population growth lowers the steady-state
level of per capita income (while it increases the total income growth rate). See text for
details.
(7)(b) Recall equation (3.5) and (3.6). It is straight forward to see that in the Harrod-
Domar model, savings and depreciation rate have growth effects on both income and per
capita income.

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Answer Keys 7
(8)(a) True. Here write down the Harrod-Domar equation. And then go on to mention
that in the Solow model, long-run growth rate is determined simply by the exogenous rate
of technical progress. The savings rate only determines long-run capital stocks per capita
and the level of per capita output, not its rate of growth.
(8)(b) False. An increase in the capital-output ratio will lower the rate of growth.
(8)(c) False. Studying countries that are currently rich introduces a bias towards conver-
gence, as you are simply selecting ex post countries that were successful and so similar.
(8)(d) True. Quah’s study of mobility of countries shows that both very poor and very
rich countries are unlikely to change world rankings all that much. In contrast, countries that
were middle-income in 1960 have shown remarkable mobility. A large fraction of them have
become dramatically richer, while another large fraction have become dramatically poorer.
(8)(e) True. In the Solow model, population growth has only a level effect on long-run
per capita income. Here you may draw a quick diagram that describes the steady state in
the Solow model and show what happens as population growth increases. Notice that in the
long-run, the rate of growth in the Solow model is just the rate of technical progress.
(8)(f ) False. Output per head increases as capital per head increases; it does so at a
diminishing rate, but it increases nevertheless.
(9) Draw this diagram. Now the idea is to show that if you start from very low levels
of income, then per capita growth tends to first decelerate as income increases. This is
because the growth of total income is constant but the population growth rate is increasing.
There is no trap because at the point where the population growth reaches its peak, the per
capita growth rate reaches its lowest point, but this point is still positive (because the entire
population growth rate lies below the total income growth line). After this stage, as the
population growth rate falls, the per capita growth rate of the economy begins to accelerate
once again.
(10) A country with a low ratio of capital to labor might grow faster for two reasons:
(1) Its marginal product of capital may be higher because there are lots of labor to work
with the capital; (2) Low capital is also likely to indicate easier upgrades or adoption of
new technologies because the old ones are hopelessly out of date or nonexistent to start
with (phone, computer, television networks for example). This is more difficult for richer
countries which have (perhaps not fully modern, but still valuable) infrastructure systems
already in place (see Problem 3 in Chapter 2, for example).
Low ratios of capital to labor may also lead to slower growth. Here are two possible
reasons: (1) A low amount of capital relative to labor often indicate that the country is poor,
and therefore its labor force probably has a low amount of human capital. If human capital is
complementary with physical capital, this will lower the marginal product of physical capital

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and result in slower growth. (2) A low ratio of capital to labor may also result in historical
lock-in of the sort described by Rosenstaein-Rodan and Hirschman (see Chapter 4). This
will result in lower growth as well.
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(1)(a) In societies with the social norm of looking after one’s ageing parents, there are
two reasons why human capital accumulation might actually be low. First, such societies
typically have higher fertility rates, because children are viewed as sources of old-age sup-
port by their parents. Because parents have more children, the cost of providing adequate
education to each of them goes up. Second, in such societies, the return (to an individual)
from acquiring human capital is lowered in two ways: (i) because more time is spent in the
home for parental care, human capital cannot be exchanged in the market for a higher wage
(so, for instance, women may acquire less human capital in such societies), and (ii) part
of the market gains from human capital may be dissipated in parental care (children with
higher incomes may have to spend more on parental care than their siblings). All this is
not to say that the norm of caring for one’s parents is a bad one; just that it has economic
repercussions.
(1)(b) When education is supplied by the free market, we will expect that some people
(those with higher private wealth) will be able to afford sophisticated education, while poor
people will not be able to acquire that much human capital. Thus societies in which education
is supplied by the market will likely display a larger inequality in the acquisition of human
capital.
(1)(c) Societies which are predominantly rural and use household labor will display a lower
net return to human capital in two ways. First, the opportunity costs of education are higher,
because children spend time on productive activity in the farm. Second, to the extent that
agricultural production does not require a mastery of technical knowledge, the incentive to
acquire human capital will be further diminished.
(1)(d) When employers cannot write long-term contracts with their employees, on-the-
job training will be undersupplied. This is because employers must bear the cost of such
training. If employees can switch jobs after such training (because long-term contracts
cannot be written), then employers may not be able to reap the benefits of their investments
in training activities.
(1)(e) If individuals with higher education can easily emigrate, and if loans are required
for education, it is unlikely that such loans will be forthcoming. This is because it will not
be easy to write contracts that guarantee the repayment of such loans. The overall effect
will be somewhat like in part (b), in which people who can pay upfront for their education
will be able to acquire human capital, whereas people who need loans for their education
will be unable to acquire such skills.
On the other hand, more opportunity to emigrate can in effect enlarge the potential
benefit of acquiring education, giving people more incentive to enhance their human capital.

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Answer Keys 9
In the cases where loans contracts can be successfully enforced, such loans can improve the
situation of the poor people who otherwise couldn’t afford the education.
(2)(a) * This part uses Calculus. Suppose that output Y is a constant-returns-to-scale

function of three inputs: Y = AH α K β L1−α−β , where H, K, L stands for human capital,
physical capital, and labor respectively, and A represents the level of technological produc-
tivity in the society. Now write down the marginal products of each of the inputs (which
will be their factor
 returns under perfect competition) by taking partial derivatives:
∂Y α−1 β 1−α−β Y

wH = ∂H = AαH K L = αH
∂Y Y
r = ∂K = AβH α K β−1 L1−α−β = β K


w = ∂Y
∂L
= A(1 − β − α)H α K β−1 L−α−β = (1 − β − α) YL
Now if the technological coefficient A is the same across countries and developing
countries have lower values of r and w, then it must be the case that YL and K Y
are lower
Y
for developing countries. But then the value of H must be higher, because (using constant
returns to scale) we cannot have all three of these fractions lower from one country to another
and yet maintain the assumption of a common technology. It follows that wH is higher.
Therefore this sort of theory poses a problem, since it suggests that while we can
explain low rates of return to physical capital and unskilled labor (in developing countries),
we must do this at the cost of accepting its implication that highly skilled labor in developing
countries get even more than their counterparts in developed countries, which is not true for
most occupations.
(2)(b) If A is lower in developing countries, then it is easy to see from the equations in part
(a) that it is possible to write down an example in which the returns to all three factors are
lower in developing countries. Moreover, the lowest relative return will be for unskilled labor
(because it is this input which is the most abundant in developing countries and therefore
most subject to diminishing returns). The return gaps for skilled labor and for physical
capital will be lower.
(2)(c) Some explanations for systematic technological differences: (1) R&D will have large
setup costs that can only be redeemed in large markets, and so it is likely that rich countries
will invest more in research. (2) The outcomes of such technical research will be most appli-
cable to countries that have lots of physical capital and skilled labor, so that countries which
have more unskilled labor will not be as well-placed to use the technology even if they could
have imitated it instantly. (3) Even if technology blueprints are known, the technology might
require support services and maintenance that are not available in developing countries. (4)
The technology might be protected by patents.
(3) Direct foreign investment is typically a long-term investment. A production plant, or

distribution center, must be set up and this entails a significant fixed cost, which will be
recovered only over the coming years. Therefore an investor looks, first and foremost, for a
climate of economic and political stability, which will assure her that a few years down the
road, the investment will still be protected.

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Direct investment must also be aware of changes in the value of the currency of the
destination country. The expected rate of depreciation of the currency must be factored into
the estimate of the rate of return on the investment. For instance, a project that will yield
50% in three years will actually yield only 20% in the investors money if the foreign currency
is expected to depreciate by 30% over the same time period.
This is not the same for short-term portfolio investment, which can be moved out more
quickly. In this case the investor typically looks at current rates of return on equity or loans
in developing countries, as well as an assurance that the currency of the country will be
stable in the short term. This is why portfolio investment is more subject to speculative
swings, in which a small real shock can spark off a “bad equilibrium” in which all (short-
term) investors move out simply because each expects everyone else to do the same (see
Chapter 5). Long-term investments are not generally subject to the same swings of mood.
(4) Assume the Cobb-Douglas production function with three inputs: Y = AT α K β L1−α−β ,
where T is the amount of land. Then if T varies from country to country, the steady states
will be different for each country depending on the amount of land. So my regression equation
that links growth rates to initial values of per capita income should also include land as an
independent variable. The conditional convergence hypothesis should then state: controlling
for the amount of land, the initial level of income should negatively inuence subsequent rates
of growth. That is, two countries with similar land holdings should exhibit a negative
relationship between their starting income and their subsequent growth rate, but no such
attribution can be made if we just put in income as the only independent variable (because
a high initial income may just be a signal of large landholdings and therefore a larger steady
state).
(5) An example for embodied technical progress is the introduction of cranes in construc-
tion, while a disembodied example would be crop rotation technique used in agricultural
cultivation. International trade could accelerate the diffusion in both dimensions, while for
disembodied technical progresses exchange of information could be critical, either through
the diffusion of Internet (an embodied technical progress) or face-to-face learning such as
student exchange programs.
(6) Open-ended question. As discussed before, although the “free” knowledge from the
more advanced world could potentially benefit the developing countries, there are many
challenges (see Problem 2/(c) in this Chapter) to be overcome before the developing countries
can actually take advantage of the technologies.
(7) Open-ended question.
1 1 1
(8)(a) ((λX1 )α + (λX2 )α + ... + (λXn )α ) α = [λα (X1α + X2α + ... + Xnα )] α = (λα ) α Y = λY
(8)(b) If there is only one kind of input, say only input 1, then the above form reduces
to Y = X1 , so that returns to scale and returns to input become the same thing. So in
this case there are no diminishing returns to input. But if the number of inputs is at least

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Answer Keys 11
two, you can easily verify diminishing returns to each input by plotting (using a graphing
calculator) how Y changes with X1 , holding all other inputs fixed at some arbitrary level.
You will see the familiar diminishing returns shape. If you know some calculus, you can take
the partial derivatives to get the marginal products of any input. For example, for Xi , we
have
∂Y X α +X α +...+Xnα ) 1−α
∂Xi
= ( 1 2X α ) α ,
i
which is clearly decreasing as Xi increases.
(8)(c) If a given amount of capital is available, it should be used to make the same quantity
of each available machine. Why is this? Well, suppose that two machines were made
in different quantities. In that case the marginal products of the two machines must be
different (because of diminishing returns to each machine and the symmetric role they play
in the production function). Then by making a bit less of the machine with a lower marginal
product and a bit more of the machine with a higher marginal product, you could increase
the total final output Y . Thus to maximize final output, the same quantity of every machine
should be produced and used.
(8)(d) Using the answer in part (d), we may conclude that capital K should be divided
into n equal parts of K/n each. Each such part will produce BK/n machines. Therefore,
Xi = BK/n for all i, and plugging this back into the production function we get that the
1−α
total output is n α BK.
(8)(e) From the expression above we conclude that Y increases as B or n increases, hence
an increase in productivity of machine-production and the variety of available machines are
both akin to technical progress. As we have seen in part (b), each input exhibits diminish-
ing returns; intuitively, an increase in machine variety counters the diminishing returns by
allowing input to be spread over a greater range of machines.
(9)(a) From section 4.4.5., we know that the income shares of capital is just M P K × KY
,
where M P K is the marginal products of capital, which is equal to the capital rent in a
competitive market. In this problem, M P K = 0.1, K
Y
=3, hence the share of capital income
is 30%. Since all output is paid in wages and rents, the income share of labor is (100-
30)%=70%.
(9)(b) Using equation (4.12), and plugging in the values given to us, we get the rate of
technical progress is T F P G = 5% − 0.3 × 3% − 0.7 × 2% = 2.7%.
(9)(c) The answer in (b) rests upon the assumption that the production function displays
constant returns to scale; if doubling the inputs results in more than twice the output, the
production function is in fact exhibiting increasing returns to scale, hence invalidating the
answer to part (b). When there is increasing returns to scale, it is much harder to get a
handle on TFP growth, but as detail in footnote 21, the answer in part (b) would be an
overestimate of TFP growth rate

lOMoARcPSD|30183549
(9)(d) Again, as is the case when production function is not constant returns to scale,
when the rent paid is not equal to the marginal productivity of capital, the answer in (b)
is not valid. If we use the monopoly rent (which is higher than the marginal product) as
the M P K, we would have overestimated the share of income earned by capital. For this
particular problem, since capital growth rate is higher than population growth rate, this
would result in an underestimate of TFP growth rate.
(9)(e) If the labor force participation rate is steady at 50%, then the answer in (b) would
still be correct (since population growth rate coincides with labor force growth rate); however,
if the participation rate is increasing over time, using population growth rate (which is lower
than the true labor force growth rate) as a proxy would lead to an overestimate of TFP
growth rate.
❈❤❛♣t❡r ✺
(1)(a) Imagine that companies have some different costs of installing fax machines (per-
haps because of different degrees of liquidity or access to credit) but that they all face a
return from installing the machines that depends positively on how many other companies
are installing. Then the graph that you draw will be upward-sloping. The more companies
that are expected to install the machines, the more will actually do so. [Important: note that
the intersections of this graph with the 45 degree line describes the equilibrium outcomes.]
(1)(b) The number of companies y who actually install the fax machines (as a function of
x2
the number of companies x who are expected to install) is given by the equation:y = A+ 1000 .
First note that if x equals 1 million, then y as given by the equation will be way over 1 million,
which simply means that everybody installing fax machines is always an equilibrium. We
x2
can find other equilibriums (if they exist) by setting x = y, and solving x = A + 1000 .
√
(1)(c) Solving the quadratic equation above, we get x∗ = 500 ± 1000000 − 4000A(when
A ≤ 250); together with the all-adoption
√ x∗ = 1 million equilibrium, we have three in total.
[Check that among these, x∗ = 500 − 1000000 − 4000A and x∗ = 1 million are the stable
ones.]Hence as increases, the equilibrium adoption of√fax machines could either not change
(when x∗ = √1 million), increase (when x∗ = 500 − 1000000 − 4000A) or decrease (when
x∗ = 500 + 1000000 − 4000A). When A exceeds 250, however, the only equilibrium left
is x∗ = 1 million. Intuitively, when contact with the outside world is sufficiently large, it
makes sense for everyone to adopt the technology.
(2)(a) If I am an evader, then I will be caught with probability 1/m where m is the total
number of evaders. If I am not caught, I pay nothing. But if I am caught, then I pay a fine
of F . Thus my expected loss is [1/m × F + (1 − 1/m) × 0], or simply F/m. As a potential
evader, I will compare this loss with the sure payment of T (if I do not evade), and take the
course of action that leads to smaller expected losses.

lOMoARcPSD|30183549
Answer Keys 13
(2)(b) This situation is like a coordination game because if one person becomes an evader,
she makes it easier for other people to evade; as the probability of getting caught decreases,
the expected losses from evasion goes down as well. In terms of part (a), m goes up if an
additional citizen chooses to evade, so that F/m goes down.
(2)(c) When nobody else is evading, your choices are:1. evade, be caught with probability
of 1, and pay fine F , or 2. not evade and pay T . Since F > T , you would choose not to
evade. This is the same for anyone in the society, so no-evasion is always an equilibrium.
Another potential equilibrium is everyone evading the taxes; this equilibrium exists when
F/N < T .
(3)(a) Our formulation captures the following idea: a person’s productivity is positively
linked not only to his own skills, but also to that of his fellow workers. But more than that is
true: note that IH −IL = (1+θ)(H −L), which means that the difference between the incomes
from low and high skills widens as more people acquire high skills. It follows that whenever
a person chooses to acquire education, he increases the return to skills for everybody else.
This is precisely the complementarity that underlies this coordination problem.
(3)(b) Assume that H − L < C < 2(H − L). First let us see if “no skill acquisition” can
be an equilibrium. To this end, suppose that no one in society is acquiring skills: then θ = 0.
If you are thinking of becoming high-skilled, then the gain in your income is IH − IL , which
is just H − L (because θ ≃ 0). Since by the assumption, H − L < C, it is not worthwhile
for you to acquire skills. We have thus shown that if everybody believes that everybody else
will not acquire skills, then no one will acquire skills. These beliefs thus form a self-fulfilling
prophecy.
Now let us see if “universal skill acquisition” can be an equilibrium. Suppose that you
believe that everybody else will acquire skills: then θ ≃ 1. Thus, if you are thinking of
becoming high-skilled, then the gain in your income is IH − IL , which is 2(H − L) (because
θ = 1). If 2(H − L) > C (which is true by assumption), then it is worthwhile for you
to acquire skills. We have thus shown that if everybody believes that everybody else will
acquire skills, then everyone will acquire skills.
Finally, there is a third equilibrium in which just a fraction of the people invest in skill
acquisition so that everybody is indifferent between acquiring or not acquiring skills. This is
given by a fraction of skilled people θ∗ such that (1 + θ∗ )(H − L) = C. This is an equilibrium
because no one is doing anything suboptimal given his or her beliefs. But you can intuitively
see why this equilibrium must be “unstable”. If for some reason the fraction of skilled people
exceeds θ∗ , even by a tiny amount, it becomes strictly preferable for everyone else to acquire
skills, and the society rapidly moves to the “universal skills” equilibrium. If on the other
hand, θ falls below θ∗ (if only by a tiny amount), everyone will desist from acquiring skills,
so that we move towards the “no skills” equilibrium.
(3)(c) & (d) If the returns to low-skilled occupations is now given by IL = (1+λθ)L, what
this means is that we are changing the “sensitivity” of low-skill income to the fraction of high-
skilled people. A higher λ means that low-skill income is more and more responsive to the
fraction of high-skilled people. Note that the difference between high and low skill incomes

lOMoARcPSD|30183549
thus becomes less responsive. To see this, observe that IH − IL = (1 + θ)H − (1 + λθ)L =
[H − L] + θ[H − λL]. Now see that if λ exceeds the value H/L, the difference between
the two incomes will actually fall as θ goes up. In this case there cannot be any multiple
equilibrium, for exactly the same reason as the traffic congestion example in the text cannot
exhibit multiple equilibria.
(3)(e) In this case, note that the cost of acquiring skills becomes infinitely high as θ
becomes close to zero, while the cost declines to near zero as θ approaches one. Thus we
see again that there are three equilibria. In the first, there is no skill acquisition because
everyone, expecting that there is no skill acquisition, feels that the cost of acquiring high
skills will be too high, and so desist from doing so. At the same time, the expectation
that everyone acquires skills is also self-fulfilling, because in this case the cost of education
is nearly zero. And there is a third equilibrium where people are indifferent between the
two options. Just as in part (b), this equilibrium must be described by the condition that
IH − IL = C(θ) = 1−θθ
.
(4) To show that a situation gives rise to a coordination problem, what one needs to do is
check if there are complementarities between the various agents concerned. In the first case
(part (a)) the agents in question are the potential defaulting countries. The more defaulters
there are, the harder it is to punish any one of them simply because it is harder for the creditor
to give up trade with several countries. Thus each defaulter creates complementarities for
other defaulters. [This may be one reason why we observed a sudden wave of defaults and
renegotiations during the debt crisis of the 1980s, instead of sporadic isolated instances of
default. See Chapter 17, Section 17.4.2. for more on the debt crisis.]
You should be able to do part (b) on your own. By this time you should also be
thinking harder about the term “complementarities”. Even though complementarities are
sometimes associated with positive externalities for other people, this is not always the case,
as part (b) shows. In its most abstract form, the term simply means: if one individual carries
out an action, it tends to increase the propensity for others to carry out the same action.
The action could be buying a new computer, evading taxes, defaulting on debt, or selling a
stock in panic, as we have already learnt.
In part (c), think about what leads to a particular region turning into a full-fledged
city. To some extent it is a question of location, but there are positive externalities at work
here as well. If an area already has a conglomeration of businesses, it makes it easier for other
businesses to set up there as well, because of access to a variety of infrastructural services.
Likewise, individuals are keener to move to such a place to work, because they know that the
amenities of life are more likely to be available there. Thus setting up life in a city creates
positive externalities (up to a point at least: later there is pollution, congestion, and high
cost-of-living to worry about), in the sense that it raises the return to others of settling in
the city as well. Think about concentrations of high tech companies in Silicon Valley or
along Route 128 in the Boston area. It is easier for a new company to locate here because it
will be easier to hire trained personnel, to have access to the latest technological knowhow,
to take advantage of the ancillary services that have prospered around these firms.
(5)(a) See Figure 5.3 for an example.

lOMoARcPSD|30183549
Answer Keys 15
(5)(b) See Section 5.2.3 for details. Roughly speaking, the government should determine
which industries to promote first based on the number of linkages they have with other
sectors and industries, the strength of these linkages, and the “intrinsic profitability” of
these industries.
(5)(c) Examples of such leading sectors are heavy industry, exports, tourism, transporta-
tion, and agriculture. Their characteristics are similar to the considerations in part(b): they
have a large number of strong linkages, and often times quite profitable.
(6) Overoptimistic entrepreneurs systematically overestimate the amount of profits from a

particular business activity, and hence they might make investments in situations where it is
not profitable from a normal economic calculation to make those investments. After they
make those crucial initial investments, however, the story might be entirely different, as the
investments could have broken off the coordination failure and sparked off a virtuous cycle
to a better equilibrium. Overoptimistic entrepreneurs are like nonconformists in the fashion
industry: because they are willing to try something new, they generate complementarities
for others who find it profitable to jump on the bandwagon later.
(7) Open-ended question. See problem 5 for inspiration.
(8)(a) One has to decide whether to throw garbage and receive a psychic dollar gain of (G−
c/n − an), or not throw garbage and neither lose an. When nobody else is throwing garbage
on the streets(n=0),the psychic gain of throwing garbage would be infinitely negative, while
not throwing garbage would generate 0 psychic gain/loss. Therefore the decision maker will
choose not to throw garbage as well.
(8)(b) When everyone else is throwing garbage on the streets, the gain to be made regard-
ing whether to throw garbage
( or not is:
G − N c−1 − a(N − 1), if throw garbage
−a(N − 1), if not throw
For whatever small value of G and c, as N becomes sufficiently large, G − N c−1 (the
difference between the psychic gains of the two actions) is going to be positive eventually,
and hence there is a threshold that once the population has surpassed it, and everyone else
is throwing on the streets, it is more profitable for the decision maker to throw on the streets
as well. It is obvious from the derivation that the threshold only depends on G and c;
intuitively, a only affects the cost that is regardless of “my” action, and hence should bear
no influence on “my” decision.
(8)(c) Such a movement is unlikely, since everyone throwing garbage on the streets is a
stable equilibrium, and hence to move away from it would require a lot of people willing
to act not upon their immediate short-term interest, and bear the initial cost of deviating
from the equilibrium. Since even “I” consider this case unlikely, everyone else is probably
thinking the same, which would only make the transition even more unlikely.

lOMoARcPSD|30183549
(8)(d) Again consider

( the payoff to the two actions:
G − F − N c−1 − a(N − 1), if throw garbage
−a(N − 1), if not throw
If F > G, then obviously no matter how large the population is, no one will choose to
throw garbage on the streets. Otherwise, one would only join the rest in throwing garbage if
G−F − N c−1 > 0, which is equivalently N c−1 < G−F . Compare to the threshold requirement
in part (b) ( N c−1 < G), we see that N indeed needs to be larger in this case.
(8)(e) If the fine is so high that no one will choose to throw garbage on the streets anyway,
this will induce a transition from the bad equilibrium to the good one where nobody throws
on the streets. As shown in part(a), this is also a stable one in the sense those who first
try to deviate will be punished most severely (even without the fine), and hence when the
transition is complete, the fine wouldn’t be necessary anymore.
(9) See Section 5.3 for detailed discussions. The ability to realize the gains from increasing
returns depends on the size of the potential market; if the large majority of the population is
already using vacuum cleaners, or the population is too poor to afford the vacuum cleaner,
or if nobody knows of the benefit of vacuum cleaners, then it is very unlikely that they can
sell enough vacuum cleaners to reap the benefit of the increasing returns from the beginning.
If the loan market is sufficiently developed, however, they could take out a loan and enter
the market anyway, bearing some initial losses in the hope of winning over the market over
time. On the other hand, if vacuum cleaners are produced under decreasing returns to scale,
the most relevant factors would be the income level of the local population and the flow of
information: as long as they can afford it and they know of the benefit of the product, firms
can still make profit even if they need to start at selling small amounts and build up their
sales over time.
(10)(a) It will choose B since the net worth is higher than that of A ($5 million vs. $4
million).
(10)(b) No. Conditional on already invested in network A, the benefit of not switching is
$6 million, larger than the benefit of switching ($5 million)
(10)(c) As this problem has illustrated, once an investment had already been made, to
switch to another system would incur substantial opportunity cost. Therefore, developed
countries that already have a relatively complete infrastructure might be reluctant to switch
to newer ones, while developing countries starting afresh only need to compare the net worth
of projects and choose the one (often the newer system) with the higher value.
(11)(a) The graph should give you a familiar diminishing-returns shape for the consumers’
valuation of diamonds (displaying diminishing marginal utility) and a straight line passing
through the origin for the cost curve of diamond extraction (Cost = 100x).

lOMoARcPSD|30183549
Answer Keys 17
(11)(b) The socially optimal rule says: diamonds should be extracted whenever the marginal
benefit of doing so exceeds the marginal cost. This means that on your graph, you simply
find the value x∗ at which the marginal utility or marginal valuation (which is just the slope
of the valuation graph at x∗ ) equals the marginal cost, which is always 100. If you know a
1
little calculus, you can see that the marginal valuation is just dV
dx
= 5000x− 2 . This equals
100 (the marginal cost) when x = 2500 (just solve the relevant equation).
(11)(c) If a monopolist had the extraordinary power of being able to charge different
amounts for each diamond sold, he, too would produce the socially optimal amount, except
that he would pocket all the social surplus from doing so. He would sell the first diamond
at the maximum valuation that the market would bear, which is just the marginal benefit
of the first diamond. Similarly, the second diamond would be sold at the marginal benefit
of the second diamond, and so on all the way down. In this way, the monopolist will also
produce diamonds until marginal benefit equals marginal cost (because each such diamond
makes him a positive profit).
(11)(d) In contrast, look at a market with many suppliers each of whom take the price
of diamonds as given. As long as the price of diamonds exceeds $100, producers will rush
in to produce, so that the equilibrium price of diamonds must be precisely $100 diamonds.
At this price how many diamonds will be sold? Well, exactly the amount such that the
marginal benefit of an extra diamond is $100. At this point we see again that marginal
benefit has been equated to marginal cost (because we just showed that marginal benefit
= 100 = extraction cost), so once again the socially optimal level of diamonds is produced.
However, note that this time all the social surplus goes to the consumers (indeed, producers
make zero profits because the equilibrium price equals the average cost of extraction).
(11)(e) Now look at the case of the monopolist once again, but this time assume that he
can only charge a single price. Now it is easy to see that production can not be at the socially
optimal level. For suppose that it were. Then for all these diamonds to be sold, the price
must be no greater than the marginal benefit of the last unit sold, which (at the socially
optimal level) equals the constant extraction cost per unit. At this price the monopolist
cannot make a profit! So he will hike the price of diamonds to a higher level. At this higher
price, the demand for diamonds (and therefore the supply) will fall short of the socially
optimal level.
Another way to understand what’s happening is to imagine a tiny price reduction by
the monopolist. This has two effects: one, it affects the monopolist’s profit, but two, it
increases consumer surplus. The monopolist reacts to the first effect but of course does not
care about the second. A maximizer of social surplus, in contrast, would have cared about
the second effect as well. This is why the monopolist, in failing to internalize the full social
gain of a price reduction, fails to maximize social surplus.
(11)(f ) Now you can see how the externalities may appear in Hirshman’s and in Rosenstein-
Rodan’s world. An investment may be not made (or it may be undersupplied) because all
the benefits from it may not be captured by the investor. For instance, the investment may

lOMoARcPSD|30183549
lower the price of an input and benefit someone else as well, but the investor (here read the
monopolist) does not internalize this benefit.
α S
(12)(a) People will all express their true views if S − 1−α
> 0, that is, if α < 1+S
.
(12)(b) First of all, M -views would always express their true views. Hence, β will always
be at least as large as α. However, what would make someone choose to misrepresent his
S
view? As we have seen in part(a), it is if β > 1+S , and when this is true, everyone will choose
to express M -view, resulting in a β = 1. Of course, β = α could also be an equilibrium,
S
given that α < 1+S and everyone is speaking the truth.
(12)(c) If there are potential conformist urges attached to each of the views L, M , and R
(and not just M ), then other equilibria might appear. There may be conformist equilibria
in which everybody announces L, or in which everybody announces R (try and provide a
simple algebraic example of this).
❈❤❛♣t❡r ✻
(1) Read the discussion at the beginning of the chapter.
(2)(a) In any one year, half the people

P have
Pm 100, and the other half have 200. The formula
for the Gini coefficient is G = 2n12 µ m
j=1 k=1 nj nk |yj − uk |, where n is the total number
of people, ni the number of people in income class i, yi the income of class i, and µ the
mean income. In our case, we can take (n, y1 , y2 , n1 , n2 ) = (1, 100, 200, 0.5, 0.5), and plug
this vector back into the expression above. The answer we get is 1/6.
Now calculate lifetime income. The expected income in the second period is 150 for
everybody (this is because there is a probability 1/2 of getting a high job and a probability
1/2 of getting the low job in period 2). Thus average income for someone currently holding
a low income job is (100+150)/2= 125, while for someone holding a high income job it is
(200+150)/2= 175. Note that because of the mobility in the economy, the expected lifetime
income gap between the high and low income groups are narrower than that in part (a); you
can calculate the Gini coefficient just as we did in part (a), and you will see that it is indeed
lower.
(2)(b) See solution to part(c), a generalization of part(b).
(2)(c) If you hold your current job with probability p, then for a low income person (today),
the expected income tomorrow is 100p + 200(1 − p). For a high income person (today) it
is 100(1 − p) + 200p. Thus expected average incomes for the low income person and high
income person are 50 + 50p + 100(1 − p) and 100 + 100p + 50(1 − p), respectively. The mean
income in this society is still 150, as you can easily see by taking the average of these two
incomes. Therefore, the Gini coefficient, calculated just as in part (a), is
1
G = 300 { 41 [50 + 50p − 50(1 − p)] + 41 [50 + 50p − 50(1 − p)]} = p6 .

lOMoARcPSD|30183549
Answer Keys 19
Note that if p = 1, this gives you exactly the same answer as in part (a), while if
p = 1/2, we get exactly the same answer as in part (b). This is as it should be. If p = 1,
there is no mobility at all (why?), so that the answer to overall inequality is the same as
the answer to inequality within a single time period. In contrast, if p = 1/2, there is perfect
mobility, which is the case studied in part (b). As p goes up from 1/2 to 1, mobility becomes
progressively lower and lower, and in response the Gini goes up, signaling greater inequality
in the presence of lower mobility.
(3) Just apply the formulae and draw the Lorenz curves. This is good practice! Let me
comment on the statement at the end of the question: understanding the implicit transfers
that are moving us from one distribution to the other. (i)[a → b]: there are no transfers, the
inequality should be the same by the relative income principle. (ii)[b → c]: there should be
no change in inequality by the population principle. You should thus get the same Lorenz
curves for distributions (a), (b), and (c)
(4) This question essentially summarizes discussion in the text. What you need to know is
that both the coefficient of variation and the Gini coefficient satisfy the Transfers principle.
This means that when the Lorenz curves of two distributions do not cross, both the Gini
and the coefficient of variation are in agreement with the Lorenz comparison and therefore
with each other.
(5) If there are minimum survival needs, then the relative income principle may need
to be suitably modified. Let us say that minimum needs cost 1000 per year to satisfy
(in some currency). Then we could apply the relative income principle to the excess of
incomes over 1000. The excess is what people have left to spend on other goods (apart
from minimum needs), and changes in these that do not aect relative excesses should leave
inequality unchanged. Here is the modified relative income principle that we might use: Let
(y1 , y2 , ..., yn ; n1 , n2 , ..., nm ) be an income distribution. Change every yi by multiplying the
excess of yi over 1000 (that is, yi − 1000) by the same constant (independent of i). Then
inequality should remain unchanged.
Note: This is only a suggestion for the purpose of this question and should not lead
you to abandon the old relative income principle altogether.
(6)(a) Take the first income distribution, x and let total income (which is just P
the sum
over all the xi ’s) be denoted by X. The poorest k people in the population earn ki=1 xi ,
Pk
xi
so their share of total income is i=1
X
. Likewise, the share of the poorest k people in the
Pk
i=1 yi
distribution y is Y
(again,
Y is total income). If the Lorenz curve for x lies inside the
one for y, it must be the case that the former share is at least as large as the latter share for
all k. This means that Pk Pk
i=1 xi i=1 yi
X
≥ Y
for all k.
Since X = Y (both distributions have
Pthe totalP
income by assumption), it must be that
k k
i=1 xi ≥ i=1 yi
(with strict inequality for at least one index k). This is what we needed to prove.

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(6)(b) Omitted.
(7) First notice the difference between the total incomes, then by the relative income
principle, scale up the second distribution by 11/10. Without loss of generality (population
principle), assume there are 10 people in the society, and hence the resulting two distributions
are:
(100,200,300,400,500,600,700,800,900,1000)
and
(275,275,275,275,275,825,825,825,825,825)
Then just check that this sequence of progressive transfers (starting from distribution 1)
does the job:


 10 → 1 : $175




9 → 2 : $75
8 → 3 : $525



 7 → 4 : $425


6 → 5 : $325
(8)(a) The beginning income distribution is given by

(1000, 1000, 1000, 1000, 1000, 1000, 1000, 2000, 2000, 2000)
and the final distribution is
(1000, 1000, 1000, 1000, 1000, 2000, 2000, 2000, 2000, 2000)
Total income in the first case is 13,000, and in the second case is 15,000. Let’s scale incomes
in the second distribution by using the relative income principle so that the sum is 13,000.
This means we multiply all incomes in the second distribution by 13/15. This gives us the
following distribution (which has the same inequality as the second (by the relative income
principle): (867, 867, 867, 867, 867, 1333, 1333, 1333, 1333, 1333)
Now focus on individuals 1 through 5. They have lost money relative to the first
distribution. Look at individuals 6 and 7. They have gained. Individuals 8 through 10 have
lost (in relative terms). This is as if there has been a “disequalizing” transfer from 1-5 to
6-7, and an equalizing transfer from 8-10 to 6-7. These transfers run in opposite directions
(and do not cancel each other out), so that the Lorenz curves must cross. You can also verify
this directly by drawing the Lorenz curves.
(8)(b) Just apply the formulae. Check to see if the Gini and the coefficient of variation
predict different directions of change in inequality. If so, why?
(9)(a) False. An example of a Kuznets ratio is the ratio of the income share of the richest
20% of the population to that of the poorest 60% of the population. Now suppose that there
is a transfer of income from relatively poor to relatively rich within the poorest 60%. Then
it is clear that the Kuznets ratio will remain unaltered.

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Answer Keys 21
(9)(b) True. Both these measures satisfy the Dalton transfers principle. This means that
when there are disequalizing or equalizing transfers, the measures go up or down accord-
ingly. But when two Lorenz curves do not cross, there must have been either a sequence of
equalizing transfers, or a sequence of disequalizing transfers, so that the two measures must
have reacted in the same direction.
(9)(c) False. Consider transfers on the same side of the mean.
(9)(d) True. The Lorenz curve cannot go above the 45◦ line at any point, say x, for if
it did, it would mean that the poorest x% of the population is earning more than x% of
total income, which is a contradiction (since it would mean that the average income of these
poorest x% of the population is higher than that of the rest).
(9)(e) False. These principles do allow us to make judgments when Lorenz curves cross,
or equivalently, when there is a sequence of Dalton transfers all going in the same direction.
When opposing Dalton transfers occur, we need a way to compare the strengths of these
opposing transfers, and the ethical principles are not sufficient for these situations. For
instance, consider the Gini and the coefficient of variation, which are both consistent with
all these principles; nevertheless they often disagree with each other in their comparison of
inequality across pairs of income distributions.
(9)(f ) True. Imagine that the original income distribution being (y1 , y2 , ..., yn ), written
in ascending order. Suppose everyone’s income increased by some a > 0 : (y1 + a, y2 +
a, ..., yn + a). Using the relative income principle, rescale the original situation so that it has
the same mean income as the post-increase distribution: (y1 , y2 , ..., yn ) = µ+a
′ ′ ′
µ
(y1 , y2 , ..., yn ),
where µ is the mean income of the original distribution. Comparing component-wise, note
′
that yi = yi (1 + µa ), hence it is larger than yi + a (i.e., relative income has decreased) when
yi was over the mean income, smaller when starting below the mean, and stays unchanged
if yi had been precisely at mean income. This means that we have a set of Dalton transfers
from relatively rich (those above the mean in this example) to relatively poor (those below
the mean in this example), which means that inequality must have fallen (by the Dalton
principle).
❈❤❛♣t❡r ✼
(1)(a) Suppose that there are 10 people and that x of them are in the modern sector. In
this case, the average income is given by
µ = 2000x+1000(10−x)
10
= 1000 + 100x
Then by applying the formula for Gini coefficient (See page 188 in the book), we get
1 x(10−x)
G = 200(1000+100x) x(10 − x)(2000 − 1000) = 200+20x
Plotting this for various values of x, you will see that as x increases from 0 to 10,G first
increases and then decreases. You can show this rigorously if you know a little Calculus; by
taking the derivative of G with respect to x, you will see that its value is first positive and
then negative.

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Similarly, we can apply the definition of the coefficient of variation:

qP
m nj
C = µ1 j=1 n (yj − µ)
2
Plugging in the numbers, we get

1
p
C = 1000+100x (1000 − 100x)2 + (100x)2
which has the exact same properties as did the Gini coefficient.
The point of this exercise is to show that the inverted U hypothesis may be (to some
extent) a statistical artifact. If development occurs through a process of migration from
traditional to modern sectors, then there may be a tendency for well-known inequality in-
dicators to first rise and then fall for precisely the reasoning in this problem. You should
remember that in this sort of processes, the Lorenz curves cross throughout, so that the
Dalton principle cannot be applied to evaluate changes in inequality at any of the stages
(except at the very beginning and the very end).
(1)(b) Note that in the process described above, inequality is very low (zero!) both at
the beginning and at the end of the process, whereas in between the inequality is higher.
Indeed, measures of inequality would most likely first rise and eventually fall in the end, but
it is possible to write down a measure that wiggles around in the middle.
(2) Your list should at least contain the ones mentioned in the book, such as Kuznets’
works, the Oshima-Kuznets inverted-U hypothesis, the Paukert study, the Ahluwalia study,
and the later ones using country fixed effects by Deininger and Squire and others.
Among many reasons that we observe the inverted-U relationship empirically are: (i)
it is to some extent an artifact of the statistical methodology that is used in inequality
measurement (see Problem 1 for example); (ii) Due to the Latin effect in cross-sectional
analysis.
(3) Suppose I have a large amount of observations for each country, then I would run
within-country regressions testing the inverted-U hypothesis separately for each country.
After all, countries differ widely from one another and it could be beneficial to allow for
some variation across countries.
However, if I had just one observation for each country, there are no within country
variations to be exploited. Therefore, in this case, I would be forced to adopt a cross-sectional
approach: to run one regression that assumes that the inverted-U relationship is identical
across countries.
In between the two extreme cases, if I have a few observations per country, an inter-
mediate approach is possible: a cross-sectional regression that includes country fixed effects.
This allows different countries to have a different inverted -U relationship, but only to the
extent of a parallel shift. We are still assuming some similarities regarding inequality across
countries, but this way the data can often be pooled in a more efficient way.

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Answer Keys 23
(4) Recall several sources of unevenness:(i) shifts from low-paying jobs to high-paying jobs,
where we showed that the Gini coefficient must rise and then fall; (ii) the bias of technical
progress against unskilled labor, which causes inequality to first rise, but then fall as the
supply of unskilled labor falls; (iii) the lack of access to education creates a high premium for
educated labor initially, which is later driven down by the increased overall level of education
of the labor force.
(5)(a) In the early stage of development, there is usually demand for skilled labor due to
the advent of a nascent industrial sector, which shifts the demand curve for skilled labor
to the right and raises their wage rates. This higher wage will draw more individuals into
acquiring skills, and hence in the long run there are two implications. First, the supply curve
for skilled labor will rise (shift to the right), attenuating or even reversing the rise in the
skilled workers’ wages. Second, the supply curve for the unskilled labor may move to the left
(if the rate of skill acquisition is very high). This may slow down the decline in the unskilled
workers’ wages, and may even cause them to rise. Putting all into consideration, the net
effect is first an increase and then a decrease in the ratio of skilled to unskilled wages over
the course of development.
(5)(b) Read the Paukert and Ahluwalia studies in this chapter.
(5)(c) This question asks you to review two things in the text: (i) An increase in inequality
will lower average rates of savings if the savings function is concave (marginal rates of savings
decline as income increases), which leads to a lower average rate of growth. Make sure
you understand this argument along with the various accompanying diagrams. (ii) Higher
inequality may trigger political demand for redistribution, and that such redistributions
often take the form of taxation of increments to assets (rather than assets themselves). As
explained in the text, such incremental taxation could be a discouraging factor regarding
investment decisions.
(5)(d) Recall from the text that there is a minimum threshold of wealth (given the wage
rate) below which access to entrepreneurial credit is impossible. If inequality goes up, more
individuals will fall below this threshold, and thus the supply of entrepreneurs goes down.
This eventually leads to a decline in the demand for labor. Together with the increased
supply of labor, the net effect is a lower equilibrium wage rate.
(6)(a) If a person has wealth A, earns wA and saves a fraction sA of income, then total
savings would be sA wA . If this savings and existing wealth earn interest at a rate of r, the
next year’s wealth is then given by (A + sA wA )(1 + r).
(6)(b) Consider the first two groups to start with. If sA = sB = s, then the ratio of today’s
wealth is A/B, and the ratio of tomorrow’s wealth (using part (a)) is
(A+swA )(1+r) (A+swA ) A
(B+swB )(1+r)
= (B+sw B)
=B ,
The last step we get by using the presumption that wA /wB = A/B. The same argument
also applies to the wealth levels of A and C, and B and C. Therefore, by the relative

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inequality principle, because all ratios of wealth are unchanged, wealth inequality next year
must be the same as that of this year.
(6)(c) First consider the wealth levels of A and B, and denote next year’s wealth level by
′ ′
A and B . Assuming sA < sB , wA /wB = A/B, and from calculation of part (a), we have:
′
A (A+sA wA )(1+r) A+sA wA A
′ = = B+s <B
B (B+sB wB )(1+r) B wB
′ ′
Similarly, B /C < B/C. Now it should be easy to check that the Lorenz curves for
wealth distribution must be worse in next year.
(6)(d) If all wages and savings rates are equal, then

′
A (A+sw)(1+r) A+sw A
B′
= (B+sw)(1+r) = B+sw > B
The last inequality is because adding a common constant (sw) to the numerator and
denominator of a fraction that’s less than one will bring up the value of that fraction. Similar
arguments apply to wealth levels of B and C, and we get the opposite conclusion of part(c):
wealth inequality as measured by the Lorenz curve must decline.
(6)(e) Think about this: what if accessible interest rates are also systematically affected
by wealth?
(7)(a) Let’s find the total income and savings of the society (total population normalized
to 1): (
0.2 × 500 + 0.5 × 2000 + 0.3 × 10000 = 4100, income
0.2 × 0 + 0.5 × 500 + 0.3 × 2000 = 850, savings
Hence the total savings rate is 850/4100 ≃ 20.7%.
(7)(b) Since the poor do not save at all while the middle-class save 25 percent each year,
the savings rate will definitely increase, which would lead to an increase in growth rate
according to the Harrod-Domar model.
(7)(c) If the growth is induced by middle-class moving up to the rich class (whose savings
rate is lower than that of middle-class people), the overall savings rate would fall and so
would the growth rate (according to Harrod-Domar).
(7)(d) Here we are looking into more details of the society: the distribution of the income
and its effect on marginal savings rates, not just the total income level.
(8) The crucial point is to understand the different effects the two policies would have on
investors’ incentives. It is the marginal ‘tax’ rate that counts, and hence a one-time transfer
means effectively no distortion of incentives between present and future (once the transfer
is done, the investors will gain 100% of their returns on all future investments), whereas the

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Answer Keys 25
redistribution from time to time means the investors may only recoup part of their returns,
and hence have less incentive to invest.
(9)(a) Let’s compare the amount an entrepreneur would get at the end of one year by
running away and not running away:
(
Run away:20000 + 0.8(30000 − 10w) − 5000 − (1 + 10%)K ∗
Not run:30000 − 10w − 20000 × 10%
where K ∗ is the amount of collateral paid at the initiation of the loan. K ∗ should ensure not
running away is the optimal choice for the entrepreneur; solving for the inequality gives us:
K ∗ ≥ 11000+2w
1.1
.
Clearly the collateral required goes up with the wages, since the higher the wages, the
lower the profit, and the less to lose when 20% of the profit is seized if the entrepreneur runs
away, and hence a larger incentive to run away. From another perspective, when the profit is
lower, it is less valuable to the creditor in an event of a run-away, and hence creditors would
demand higher collaterals to guard against the risk.
(9)(b) For w = 500, with the expression above, we have K ∗ ≃ 10910. When the supply
of labor exceed its demand, some people will be unemployed. If x% of the population (say
population is N ), then labor supply is N ×(x%), whereas labor demand is [10×N ×(1−x%)].
Supply is larger than demand when x% ≥ (100/11) ≃ 91%.
(10) The higher interest rate has no effect whatsoever in the event of a default, and is there
as a premium to risky borrowers, compensating for the more likely defaults by charging more
when the loan is in fact repaid. However, one serious problem with the interest rate is that
as it gets higher, it also induces a higher probability of default; once the default risk starts to
increase with the interest rate, it may be impossible use the interest rate alone to compensate
for the potential defaults, and a cap on loan sizes comes into play.
(11) See Problem 5 and Problem 9. We’ve seen in Problem 9 that when wage rates are
low, business profits are higher and hence there is a lower risk of default, and therefore access
to loans are generally easier in those situations.
Next, assuming all those who can not set up a business as laborers, and going along
the logic in the previous paragraph, a higher wage rate would make it harder to set up a
business, and hence increase the supply of laborers. This way the supply curve of labor is
upward-sloping, and similarly, the demand curve is downward-sloping. Their intersection
determines the equilibrium wage rate.
When the distribution of income become less equal, at every wage rate less people will
be able to borrow from the credit market than before, and hence the supply curve shifts to
the right, while the demand curve shifts to the left, lowering the equilibrium wage rates.
(12) With better information regarding borrowers and their credit histories, the credit
market will be in a better position to screen out the ‘bad’ borrowers. Formally, in equation

lOMoARcPSD|30183549
(7.4), F (the expected cost of default) will rise with better screening and enforcement, thus
lowering the minimum wealth required for access to credit. With easier access to credit,
more entrepreneurs may advent, labor demand will rise, drawing those who were in the
subsistence sector back into the labor force, and eventually resulting in a higher output.
[Note that similar results can be obtained even if all workers are in the industrial sector
already, provided that employers don’t hire a fixed number of workers.]
❈❤❛♣t❡r ✽
(2) Open-ended question. International poverty calculation, by definition, is hard to incor-

porate social- or cultural-dependent factors into its calculation, and hence should be taken
with this caveat born in mind.
(3)(a) See the first two examples in Section 8.2.2.
(3)(b) As mentioned in the Introduction section of this Chapter, consumption per capita
grew a lot over this period, but the absolute number of poor people is still staggeringly high.
(3)(c) Poverty gap ratio and income gap ratio are similar measures in the sense that they
are a ‘relative’ measure, though the latter captures more directly the acuteness of poverty.
(3)(d) Indeed. See example 3 in Section 8.2.2.
(3)(e) The larger α is, the greater the weight given to large gaps (the poorer among the
poor) is.
(4) ???I am probably wrong but it seems that we can’t say much about the Cp ’s for A and
B...say we let CA = CB = C, then looking at the quadratic function
C2 2 C
f (I) = I 2 + (1 − I)2 C 2 = (1 + C 2 )[(I − 1+C 2
2 ) + ( 1+C 2 ) ],
the lowest point of the function is always obtained at an I within 0 to 1, and hence it is always
possible to choose IA > IB such that f (IA ) < f (IB ), and so we can have F GTA = F GTB
with HCRA > HCRB . Now changing C slightly shouldn’t affect the result, so we should be
able to have all three possibilities CA = CB , CA < CB , CA > CB ???
(5) If the borrower’s project guarantees future income security, the threat to cutoff his
future credits would be less intimidating, and therefore there is a greater chance that the
borrower would default. In these situations, the requirement of some upfront collateral can
serve as an incentive mechanism to ensure the borrower to repay the loan even if he doesn’t
need any credit anymore in the future.

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Answer Keys 27
(6)(a) You should first graph the capacity curve as described. The cost of the project can
be calculated as the total amount of work divided by the average amount of work done for a
dollar (call it k). Hence, to minimize the cost, we would like to maximize k. Notice that it
requires at least $100 to get a worker to start working, and so before $100, k = 0. Between
$100 to $500, k = 2(x−100)
x
= 2 − 200
x
, where x is the amount paid to a worker. Clearly k is
increasing throughout this period. Similarly, k starts to decrease from $500 onward. Hence
it is best to pay a worker $500 and get 800 units of work. In this manner, we would need 10
workers at the cost of $5000.[In terms of the capacity curve graph, for any x, k is just the
slope of the segment that connects the origin and the capacity of the worker at x; hence, to
maximize k, just look for the point where the slope is the steepest.]
(6)(b) In a similar fashion, verify that this time k would keep increasing up to a worker’s
full capacity (i.e. 1000 units of work for $1000). Therefore this time we need 8 workers
and we pay them $1000 each, a total of $8000. This is because as the minimum nutrition
requirement rises, the fixed cost for hiring each worker increases, and we would need to
contract the worker for more work in order to spread out the fixed cost and lower the
average cost.
(7)(a) Nonlabor income is valued at $400.If this is divided equally everyone gets $80h.
Now, if x units of capacity are supplied by each member, his labor income is x/2 dollars(given
the piece rate); plot the capacity curve in question (6)(a) (shifted left to account for the
nonlabor income of $80) and show that the piece rate line and the capacity curve have no
intersection. This means that equal division will leave the family in a position where they
are unable to supply capacity on the labor market (since an intersection is where the wage
[together with the $80] is just enough to buy the nutrition required for the amount of labor
the worker provides).
(7)(b) From the above argument, it should be clear that only those allocations of nonlabor
income which give some household members at least $100 (before they start working in the
labor market) will permit positive work capacity to be supplied.
❈❤❛♣t❡r ✾
(1) Consider the following hypothetical example:

For country A, 44% of the population are under 15 and display a death rate of 10 (per
thousand, same for death rates below), 53% of the population are under 64 but older than
15 and display a death rate of 5, and finally 3% of the population are above 64 and display
a death rate of 50.
For country B, 19% of the population are under 15 and display a death rate of 7, 67%
of the population are under 64 but older than 15 and display a death rate of 4, and finally
14% of the population are above 64 and display a death rate of 40.
In this hypothetical example, country A has higher death rates in every category com-
pared to country B. Let us calculate the overall death rates, which are given by a weighted
average of the age-specific death rates, using population shares as weights. For A it is

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10 × 0.44 + 5 × 0.53 + 50 × 0.03 = 8.55, while for B it is 7 × 0.19 + 4 × 0.67 + 40 × 0.14 = 9.61,
higher than that of A.
(2) Because of the younger population composition, a larger fraction of the population are
on the threshold of marriage and reproduction. Thus, even if one were to reduce the fertility
rate per couple, the overall birth rate could still remain high (macro-inertia). The same
argument shows that even when the fertility rate is dramatically reduced to steady state
levels, the population still continues to grow for a while. This is because the percentage of
couples who are having children is very high, and that this rate is most likely higher than
the death rate in the population. This effect will slowly disappear as the reduced fertility
rate finally has an impact on the age distribution, but this usually takes decades.
(3) Open-ended question. Read section 9.3 for guidance.
(4) Consider a world with only two countries, where the ‘ideal’ (leaving out any militaris-
tic or international political goals in mind) population is 1 million for both countries. For
militaristic or international political reasons, both government would want to have a larger
population than the other (perhaps because then it could raise a larger army). The magni-
tude of these political gains are determined by the relative difference between the populations
of the two countries, rather than the absolute levels of population, so that if both countries
encourage similar population growth, in the end there would still be very little population
difference between the two, while they have both exceeded their ideal population and hence
are bearing some extra costs. This way, they are locked into a Prisoners’ Dilemma: Although
a joint bilateral policy of population reduction could benefit both countries, neither country
would want to unilaterally revert to its ideal population size first (because then a negative
population gap will open up between it and its rival).
(5)(a) The probability of x children all failing to survive is (.5)x , and hence the probability
of at least one child surviving is 1 − (.5)x . Setting this to p we get x = log 1 (1 − p). Clearly
2
as p increases (from 0 to 1), (1 − p) decreases (from 1 to 0), and the corresponding x goes
from 0 to infinity.
(5)(b) The expected number of surviving children would be the survival rate (.5) times x:
.5 × x = .5 × log 1 (1 − p).
2
(6) A couple might aim to have a certain number of kids (who can survive to adulthood).
This may be for several reasons, the most important of which, as discussed in the text, is a
source of security for the couple when they grow old. How should they pace their reproductive
decisions? It depends on the mechanism through which the uncertainty operates. For
instance, if all the uncertainty lies in infant mortality, the couple can wait to see whether the
first child survived before deciding whether or not to have another baby. This conditioning
of future reproductive decisions on the outcomes of earlier events is called targeting.
On the other hand, uncertainty regarding success may resolve itself late. There may be
significant levels of child mortality even after their infant period. There may be uncertainty

lOMoARcPSD|30183549
Answer Keys 29
regarding the economic success of the kids, and uncertainty regarding whether the kids will
look after the couple even if they are economically successful. These uncertainties often
force the couple to make all its fertility decisions before knowing the how some of these
uncertainties would unfold. This mode of reproductive behavior (hoarding) typically gives
rise to greater fertility, simply because the couple must try to compensate for the risks in
advance.
(7) Couples often use the experience of their parents to draw inferences about the prevailing
rate of survival in the current generation; this use of personal experience almost always
underestimates the probability of survival, simply because the society is constantly improving
in various aspects such as sanitation, health facilities, and medical care. Therefore, the use
of personal experience (of the parents) as a guide to fertility decisions will very often lead
to a higher than ‘necessary’ fertility rate.
The media can counter this by informing the population of the higher survival rates in
today’s society, as well as the advantages of having fewer children. Media such as television
are often more easily understood and accepted by the mass, compared to accurate but
somewhat dull statistical analysis.
(8) One reason parents have a lot of child is that they expect to gain some income from
the children; by implementing a ban on child labor, it effectively reduces the benefits of
having a child (for some parents), while the cost is unchanged. In a cost-benefit analysis,
the (cold-hearted) parents would probably decide to bear fewer children.
(10)(a) Men would earn more since they have more physical power than women (and
the same mental power). The magnitude of the difference would depend on the difference
between the marginal productivity of physical labor and that of mental labor.
(10)(b) Due to the type of technology in this society, increases in capital result in a relative
increase of return to mental labor (compared to the return to physical labor). Since women
have a comparative advantage in mental labor, one would expect the relative wages of women
to rise.
(10)(c) Since the changes would result in an increase in women’s wages, we should expect
to see women allocate more time in the workforce and less time in child-bearing. Hence, the
fertility rate in the population would likely decrease.
(11) In contrast to the U-shaped relationship proposed in this question, the preceding
question suggests that the participation rates of women should rise as their relative wages
rise. The reasoning in the last question could possibly account for the second half of the
U-shaped relationship, that is, the part where participation rate increases with per capita
income.

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There are many potential explanations for the part where participation rate falls as
income increases. For example, in very poor societies, women may need to work day and
night only to maintain a subsistence level of living. As per capita income increases, women
may finally afford to drop out from the labor force from time to time.
(12)(a) Although developing countries usually have a higher age-specific death rate in
each age group, it is not fully captured by the overall death rate since developing countries
usually also have a younger population, which biases downward the overall death rate.
(12)(b) True. See Table 9.3.
(12)(c) Not necessary. It depends on the age distribution of the population. It is possible
for the fertility rate in one country to be lower than that in another country, and yet for
the population growth rate in the former country to be higher. You can try to construct an
example as in Problem 1.
(12)(d) True. Discussed in the demographic transition (phase 2, in particular).
(12)(e) True. This would shift parents’ fertility decisions from hoarding to targeting, the
latter of which usually leads to lower fertility rates.
(13) See section 9.3.2. For example, one reason is that the fall of death rate in the now-
developed countries were gradual (due to the trial and error of innovation and so on), while
the developing countries can take advantage of the pre-existing stock of knowledge and speed
up the process of the Phase-2 demographic transition.
(14) I would test the hypothesis that among all the last child within a household, the
male-female ratio is 1:1. If the data reject this hypothesis (in favor of a ratio larger than 1),
it would suggest the existence of potential gender bias in favor of boys.
(15)(a) This is similar in spirit to Problem 14. If families choose to have children until
they have one son, and then they stop, all the possible birth patterns are:
(boy); (girl, boy); (girl, girl, boy); (girl, girl, girl, boy), and so on.
Now it is obvious that larger families (families with more children) have more daughters
(among the offsprings).
(15)(b) Since girls are also more likely to be in a family that has more children to take
care of, even if she is treated equally within the family, she is still more likely to die (on
average) compared to other boys in the society (because larger families on average have less
resource to spend on each child, not just the female children).

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Answer Keys 31
(16)(a) Note that the marginal benefit of each additional child is decreasing. That of the
second child is $250, but that of the third is $90, so the couple will have two children.
(16)(b) If 50% of the costs are passed on, the marginal cost becomes $50, so that now
they will have four kids each (by the same reasoning as in part (a))
(16)(c) Since now the cost is shared with the relatives, while the benefit is retained by
the couple, when doing the cost-benefit analysis, each couple would choose to have more
children. In this case, each additional child creates negative externality to the joint family,
and causes the size of the family to increase to a sub-optimal level.
(17) Open-ended question. Read section 9.4 for a thorough discussion.
❈❤❛♣t❡r ✶✵
(1) See section 10.1.2 for a detailed discussion. Formal sectors are much more heavily
regulated partly because of the existence of government and unions, but also receive many
benefits that are exclusively accessible by the formal sector.
(2) Agriculture supplies the industrial sector with labor and food, while the industrial
sector provides the necessary inputs for agricultural sectors (such as tractors and fertilizers).
A number of factors affect these flows: international prices, technological change, market
regulations, etc. Discuss how each of these (and other) factors affect the following things: the
flow of labor from the agricultural sector to the industrial sector, the demand for labor in the
agricultural sector, the demand for labor in the industrial sector, the supply of agricultural
goods, and the demand for agricultural goods in the industrial sector.
(3) See section 10.2 for detailed discussion.
(4)(a) In the surplus labor phase, the marginal product of agricultural labor is (close to)
zero. If some members migrate to a new place, then output in the family farm doesnt change,
but there are fewer people working there. Thus, the average income of the farm goes up.
(4)(b) In the surplus labor phase, there is a perfectly elastic supply of labor to the in-
dustrial sector. This means that at a given wage rate, there is a large number of workers
willing to go from the agricultural to the industrial sector. This would not be true if agri-
cultural workers earned the average output of their farms: as people leave the agricultural
sector, average output goes up and so would the industrial wage needed to induce workers
to migrate.

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(5) In the disguised unemployment phase, the agricultural wage is still w, but each worker
that leaves for the industrial sector reduces average agricultural surplus. At the same time,
in order to attract workers, the industrial sector needs to compensate workers for the agri-
cultural income they leave behind. However, as there is simply not enough food to go
around anymore, the workers must live with fewer agricultural goods, but more industrial
goods. When the society is close to a subsistence level, the workers would rather work in
the agricultural sector and produce food for own consumption.
At what rate will workers trade agricultural income for nonagricultural income? It
depends on the marginal utility of agricultural versus nonagricultural goods. Agricultural
goods are used essentially as food, while industrial goods are used for other purposes. When
initial income is close to subsistence, a unit of food is worth much more than when initial
income is higher. If food can be freely traded in the international market, that makes
industrial output more valuable (since they can trade for food). Thus, the curve should be
flatter (a more elastic labor supply).
(6) In the Lewis-Ranis-Fei model, capital accumulation increases the demand for labor in
the industrial sector (it shifts the entire curve upwards). A tax on industrial labor will reduce
capital accumulation, resulting in a lower demand curve than would be observed without
the tax.
Part of the cost of a tax, from an industrial worker’s perspective, is the lower equi-
librium wages. The benefit of such a tax, on the other hand, would be the income to each
worker from the redistribution. Thus, workers will be more willing to lobby in favor of the
tax the lower the reduction in wages, and the higher the potential redistributional benefits
per worker.
Three possible cases are depicted in the figure below. After tax curves are in dashed
lines. In the surplus labor stage, wages do not change in response to a small tax, while on
the other hand, tax revenue will be positive. Hence, workers will be more likely to benefit
from the tax. The other two cases show how steepness of the supply curve affects the change
in equilibrium wages: the greater this change, the lower incentive the workers have to favor
taxes.

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Answer Keys 33
(7)(a) The figure below plots total output as a function of total employment. At any
level of employment L, wage payments to labor are wL, so that they can be represented
by a straight line from the origin with slope w. Everything below the line is consumed,
and everything between the line and total output is reinvested. The profit maximizing
employment level L∗ is achieved when the slope of the output curve equals w (in other
words, when wage equals marginal product).
(7)(b) Suppose that there is a social planner who cares about consumption today and
consumption tomorrow, where consumption tomorrow depends on the level of reinvestment
today. Now, by looking at the previous graph, you can tell that any level of reinvestment
(other than the maximum) can be obtained by two employment levels: one below L∗ , and
one above it.
Suppose the planner chose an employment level L e < L∗ . From our observation above,
e > L∗ with an identical profit level. In terms of consumption tomorrow, these
there is an L
are equivalent (since they result in the same reinvestment). But the L e will have higher
consumption today, as there are higher wage payments. So, the planner will never choose
e This argument can be made for any employment level strictly below L∗ . Thus, we have
L.
shown that the planner will always wish to choose an employment level not less than L∗ .
(7)(c) Say the planner wishes to employ L b units of labor, as in the figure below. A possible
way to do this is to subsidize employment by giving the employers an amount s for every
hired worker. This effectively reduces the wage the employer pays from w to w − s. With
a lower wage, a profit maximizing firm will demand more labor. Adjusting s appropriately
b
leads to the target L.

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(8)(a) Pims expected return in the agricultural sector is 1000 nice. Let us call f the ratio
of formal jobs to total urban labor force. If Pim moves to the urban sector, she will get a
formal job with probability f , or else work in the informal sector. Therefore, the expected
value of working in the urban sector is 1200f + 500(1 − f ) = 500 + 700f . This is increasing
in f , and it equals the return in the agricultural sector when f = 5/7.
(8)(b) In order to maximize total family income (in expected value terms), the return to
moving to the urban sector should be higher than the agricultural output that is lost by
leaving the farm (that is, higher than marginal output in the farm). We can see this point
by writing total income in terms of the number of sisters who work the farm.
We can see that by moving, Pim increases total family income from 4000 nice to 4300
nice, and therefore she will move.
(8)(c) If all they care about is total family income, then looking at the table above, we
conclude that at least one more sister would be willing to migrate to the urban area.
(8)(d) Depending on what the sister aims to maximize (own income or total family in-
come), the migration decision is very different. This is because even though staying at the
farm can provide a pretty decent income for the sisters, the marginal productivity of the

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Answer Keys 35
fourth sister is actually quite low, and migrating to the urban area not only increases her
own productivity but also increases that of her sisters.
(9)(a) In this case, expected income in Mexico City is 0.5 × $1, 300 = $650. That is the
expected income of each brother should he decide to migrate. Now, since brothers share the
output of the farm, depending on the number of brothers working in the field, their income
will be given by the following table.
The equilibrium is one brother migrating to the city: When there are five, income in
the farm is lower than income in the city, but when only four remain, they no longer have
an incentive to move.
(9)(b) If family members share the output equally, then they have an incentive to maximize
total output. This is done by equalizing marginal output in the farm to income in the city.
If equality is not possible, then brothers will leave the farm as long as their marginal product
is below the expected income in the city (why?). The next table shows marginal agricultural
output and total family income with respect to the number of brothers working in the farm.
Income in Mexico City is constant at $650.
Hence, two brothers will stay at the farm, and the rest will move to Mexico City.
(9)(c) Now, the income gained from going to Mexico City is $850, as long as at least one
of the brothers remains in the farm; if no brother remains in the farm, then they all get
$650. The next table shows income going to the brothers that remain in the farm.
Note that it is always profitable for a brother who is in the farm to move to the city. Thus,
they all will.
(9)(d) As we go from part (a) to part (c), indeed the level of altruism varies as does the
the number of brothers leaving for the city. Naturally, the higher the level of support from
the family for the migrants, the more brothers would choose to leave for the city.

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(10)(a) False. In the phase of disguised unemployment, marginal productivity of labor in

agriculture is positive, which makes average surplus go down as workers migrate to the city.
There is less agricultural output available for each industrial worker, and this means workers
will only move if the wage goes up in terms of industrial goods.
(10)(b) If there is no market for agricultural labor, then this could be true. Inequality
in landholding matters only if there is no mechanism to distribute labor efficiently across
households. Say land holdings are distributed very unequally, so that some families work
very large plots and others very small plots. We could be in a situation where there is surplus
labor in the small farms, and transferring some of them to a large plot would raise output in
the large plot; when there is no labor market, this cannot happen so the workers from the
small plots migrate. Thus, migration would be faster than if all plots were the same.
(10)(c) False. Migration restrictions, if they are well enforced, allow people into the urban
sector only if they hold a formal job. Therefore, the informal sector shrinks dramatically.
On the other hand, it results in inefficiently many people in the agricultural sector.
(10)(d) True. Say labor demand increases. At the going formal wage,w, demand grows
′
from Lf to Lf . If this gap is filled by informal workers, we have that the expected wage
′ ′
L L LI −(L −Lf )
f
in the urban sector goes from Lf +L I
w + LfL+L
I
I
f
wI to Lf +L I
f
w + Lf +L I
wI Since w > wI ,
this wage has gone up, so workers migrate from the agricultural sector, which raises the
agricultural wage, wA . This means that for workers to be willing to migrate from agriculture,
the expected urban wage must be higher than at the original equilibrium. Since wages in
the urban sector are fixed, this can only be true if a higher share of the urban population
works in the formal sector.
(10)(e) True. Even in the surplus labor phase, a worker leaving the agricultural sector
increases output per worker. If this increase is not taxed away, then labor supply should be
upward sloping.
(11) See the first part of section 10.3.4. When governments try to channel workers from
informal sector to the formal sector, things do not end there. Instead, migration will also
rise in response and the informal sector might become even larger afterwards.
(12) See the second part of section 10.3.4 for detailed discussion. The flexible equilibrium
allocation is efficient when the demand curves arise through competitive profit maximization
(and hence they correspond to the value of marginal product).
Physically restricting migration gets rid of the informal sector, but relative to the
efficient allocation, too few people are in the city while too many are in the rural area. On
the other hand, government can try to subsidize firms to hire workers into the formal sector,
attracting workers from the informal sector as well as workers from the agricultural sector.
However, this would lead to too many people in the urban sector relative to the efficient
allocation.

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Answer Keys 37
(13)(a) (i) 100 ∗ 0.4 + 200 ∗ 0.5 + 0 ∗ 0.1 = 140

(ii) 100p + 200(1 − p) = 200 − 100p ; The expected value decreases as p increases, which
makes perfect sense since your chance of winning the higher prize is getting lower.
(iii)100p + (1 − p)[50q + 200(1 − q)] = 200 − 100p − 150q + 150pq
(iv) 100p + 200q + 300r
(13)(b) The expected value of the lottery is 1000 ∗ 0.1 + 200 ∗ 0.9 = 280. If you are risk-
neutral, this is the maximum you would pay to enter the lottery. If you were risk averse,
you would be willing to pay less, not more. If a risk averse agent were willing to pay 600,
the expected value should be at least 600, which is true whenever the probability of getting
1000 is 0.5 or higher.
(14) Any rule that doesn’t give A the same amount in both cases cannot be efficient. This
is because if the amount is different, A can always ask for the average of the two payoffs (for
both cases), and if B had agreed to the rule before, he would agree to it again since it makes
no difference to him (a risk-neutral person only cares about the average amount he gets).
However, A is strictly better off since he is risk-averse, and hence any rule that doesn’t give
A the same amount in both cases is strictly dominated by some other rules.
❈❤❛♣t❡r ✶✷
(1)(a) Each acre produces $3,000 worth of output. If it is leased, the tenant will have to
pay $1,100 in wages to each of the two required laborers. Therefore, the rent the family can
hope to obtain is $3000 − 2 × $1100 = $800.
(1)(b) Each acre requires two people to farm it. Since output per acre is $3,000, this
amounts to $1,500 per person. Say two of the family members are available to either work
the land, or earn wages in the labor market; working the land will yield $3,000, while leasing
the land and having both members work elsewhere yields $800 from the lease and 2*$1, 000
= $2, 000 in wages, and hence a total of $2,800. Therefore, the family will always find it
optimal to work its land if it can, and a family of six will only lease land if it owns more
than 3 acres.
(1)(c) Recall that a supervisor can oversee any amount of laborers. For each acre that
is worked in this way, there will be $2,000 in wages. Therefore, the profits from hiring a
supervisor and laborers, for a given acreage s is $1, 000s − $2, 000.
First, note that once the family hires a supervisor, it no longer needs to work the land.
Indeed, if the family owns a total of a acres, and leases l acres, its income will be
$9, 000 + $800l − $2, 000 + $1, 000(a − 3 − l) = $4, 000 + $1, 000a − $200l
if it works the land, and
6 ∗ $1, 000 + $800l − $2, 000 + $1, 000(a − l) = $4, 000 + $1, 000a − $200l

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if it works outside instead. From the equation above, we see that if it hires a supervisor,
the family will not lease any land (it would reduce total profits). When will the profits from
farming its own land and leasing be less than the profits from hiring a supervisor? Whenever
this holds:
$4, 000 + $1, 000a > $9, 000 + $800(a − 3),
that is, a > 13. So, whenever the family owns more than 13 acres, it will hire a supervisor
and not lease any land. Note that we have shown that the optimal pattern of production for
a family of six is:
This helps to assess the statements in the problem:
(i) A high degree of equality in land ownership would in general mean relatively small farms.
From the problem we have seen that it is often more profitable to work on their own lands
when the farm is small.
(ii) Very high inequality means some farms will be very large, and others very small. Large
farmers would choose to hire labor, whereas small landowners would work their own land
and possible have some family members work elsewhere.
(iii) Moderate inequality means there will be several farms large enough that the family can-
not work them by themselves, but not large enough to make capitalist production possible.
Hence, tenancy will be common.
(2)(a) Consider for example the ownership of bullocks. We have seen that the rental
market for animal power is usually quite thin, so that animals are usually used by their
owners. If bullocks are owned relatively equally, then an efficient allocation would have each
owner farming a similarly sized plot. If initially land ownership is very unequal, land will be
leased to tenants who own their animals; if initially it was relatively equal, it will remain like
that. In either case, the operational distribution of land will be equal. However, if instead
the ownership is uneven, we would expect owners with a large number of animals to work
large farms, possibly hiring labor. A similar reasoning applies to other asset ownerships as
well.
(2)(b) In the efficient allocation, the operational distributions of all three inputs will co-
incide. In order to obtain this, we will generally need two functioning markets. If only
one market functions properly, say the market for labor, then labor can be redistributed
to match one of the other input’s distribution, but the third input would still be allocated
inefficiently. Note how the final operational distribution depends on which input market
is not functioning: since one of the inputs cannot be redistributed, in order to achieve the
efficient allocation, the markets for the two other inputs would have to redistribute resources
to match the distribution of the input that doesn’t have a market to be traded in.

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Answer Keys 39
(3) Read section 12.2. for detailed discussion. Notice that farm size in Latin America is
on average larger and less equally distributed than those in Asia, while Asian farmers are
much more likely to be in a shared tenancy when compared to Latin American farmers, who
usually signs fixed-rent contracts.
(4)(a) In an economy with well functioning crop insurance, tenants can make sure that
they obtain the expected value of the crop. Therefore, compared to a shared cropping
contract, there is no loss for even the risk-averse tenants from paying a fixed rent (recall
that this is not true when insurance is not perfect). At the same time, fixed rent ensures
that tenants will make the efficient decisions since there is no distortion at the margin. As a
result, landowners will also be willing to offer fixed-rent contracts since those induce a higher
productivity and they could potentially charge a higher fixed rent as well.
(4)(b) If the inputs can be monitored perfectly by the landlord, then there is no efficiency
loss in sharecropping: the optimal level of inputs can be contracted. However, there is less
risk in a sharecropping arrangement than in a fixed rent arrangement (with equal expected
payments to the landlord). This means that the tenant will strictly prefer a sharecrop-
ping arrangement with equal expected income. But then, this implies that for any fixed
rent arrangement that is acceptable to the tenant, the landlord can offer a sharecropping
arrangement with lower expected income for the tenant, which he will accept because of
the reduced risk. Since there are no incentive costs, this implies that profits to the landlord
would be higher. Thus, no landlord will choose to offer a fixed-rent tenancy in such a society.
(4)(c) If inputs are not verifiable, then we cannot be sure that the expected output under
both arrangements (fixed-rent and shared cropping) will be the same. There would be
incentive problems under both types of contracts, and which one turns out to be better
would depend on the particular features of each problem.
(5)(a) Since the opportunity cost of working in the cooperative is the wage rate, w, farm
surplus would be maximized if both farmers work until the marginal product of their com-
bined efforts equals w. The total cost would be a straight line through the origin with slope
w, while the production would be a curve starting steep out from the origin but leveling out
as labor input increases. The point of maximization is where the slope of the production
curve (i.e. the marginal product of labor) equals w (the marginal cost of labor).
(5)(b) Now marginal product for each worker is half of what it used to be, but each worker
will still work until his marginal product is w; since there is diminishing returns, the level
of labor input that achieves this is lower than that in part (a). (Diagrammatically, now we
need to find the point where the slope of the production curve is 2w.)
(5)(c) Each worker will always try to equalize the marginal product and cost he is facing.
As s increases, marginal product for farmer 1 increases, but that for farmer 2 decreases.
However, the marginal cost for both workers are the same, and hence it can not be the case
that both farmers choose to work (otherwise the marginal product faced by the two farmers

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would have to be the same, which is impossible). Therefore, farmer 2 would choose not to
work at all (while still benefiting from farmer 1’s labor); farmer 1 will work sub-optimally
until s reaches 1 (when he can claim all the products to himself).
(5)(d) Now the cost function is a curve from the origin that starts out flat but becomes
steeper as labor input increases. To find the maximization point, as always, we find the
point where the slopes of the two curves coincide.
(5)(e) Now it is possible that both farmers are supplying labor even when they get different
shares. This is because at very low levels of individual effort, marginal cost is low, and
this will make it possible to equate the marginal return from labor (which is a share of the
marginal product) with its marginal cost. From any aggregate amount of labor, the marginal
return for farmer 1 is higher than for farmer 2, so that at an equilibrium farmer 1 will supply
more labor.
Note that for any level of total output, we will have an inefficient allocation of labor.
Since the marginal costs are increasing, the most efficient way to achieve any given output
level is to have both individuals supplying the same labor amount, which is not the case
here.
(5)(f ) When the output is shared among members, the effective marginal product that each
member perceives is lower than the true marginal product of his labor. This disincentive at
the margin often results in inefficient outcomes.
(6) If outputs and costs are shared equally, then the farmer faces a similar tradeoff between
input cost and production to the case when he is responsible for all the costs and receives
all the output. In other words, his decision will more likely coincide with the optimal choice
of the landlord.
(7)(a) With this tenant law in mind, the landlord may try to evict the tenant before the
tenant is qualified to obtain permanent use rights (while he may have allowed the tenant to
continue working in the land if there hadn’t been such a law).
(7)(b) In the presence of limited liability, there might be situations where the tenant is
unable to pay the rent. In these cases, part of or even all of the rent may have to be forgiven.
Therefore, the tenant has an incentive to over-invest in highly risky methods of production.
To counter this incentive, the landlord can use eviction as an additional threat to prevent
this from happening.
Banning eviction may cause some productivity loss (since the landlord loses a tool to
incentivize the farmers to work harder), though on the other hand, banning eviction also
increases the bargaining power of the tenant. Higher share of the output the tenant can get
leads the tenant to choose the labor input closer to the efficient level.

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Answer Keys 41
(8)(a) Say both large and small farms have the same decreasing returns production func-
tion f (l), where f is output per acre and l is labor per acre. Profit maximization in both
cases requires equating the marginal product of labor to its marginal cost. For large farms,
this cost is the market wage, w. For family farms, which use family labor, it is the expected
return to a family member entering the labor market. This is the market wage, weighted by
the probability of finding a job. Call the unemployment rate u, then the marginal cost of
family labor is (1 − u)w. Thus, family farms will choose a higher level of labor per acre, and
therefore a higher level of output per acre.
(8)(b) In this alternative explanation, we can imagine that originally all plots are the same
size. However, they differ in fertility. This means their production functions are different.
With the same initial labor effort, one type of plot yields more output, and this leads to its
sustaining a larger family. As a consequence, in the following generations this plot would
be divided into more subplots tfor each new family. This means that after a generation, the
more fertile plots are smaller than the rest. So we observe that smaller plots have higher
output per acre, even if the opportunity cost of labor in each plot is the same.
(8)(c) (i) In argument (a), the differences in the size of the plots lead to differences in
labor market characteristics and thus differences in observed land productivity. In contrast,
the underlying factor in (b) is land productivity, which leads to different offspring sizes and
ultimately different plot sizes.
(ii) In the case of part (a), the government has a motive to try to redistribute land
holdings. This could come by making the market for land more efficient. This intervention
is justified because any efficient allocation of land and labor should equate the marginal
product of labor across all landholdings. In case (b), it may not be justified to intervene at
all, unless there are gains from increased farm size in terms of the technology that can be
used.
(8)(d) If we have data on land productivity in a region where a land reform have just
been carried out recently, we can check whether the inverse relationship still holds there. If
it does, than it is more likely for argument (a) to be true, since it would require some years
for argument (b) to start showing its influence.
(9) Open-ended question. In general, the more ownership one has over the land, the
more incentive he will have to work harder and invest more in the land (and hence increase
productivity in the land).
❈❤❛♣t❡r ✶✸
(1) Read section 13.3 for extensive discussion. Some major distinctions from standard
models are: 1. There is a distinction between casual and long-term labor that is not captured
by standard models; 2. There is a distinction between labor power and laborers that is
not captured by standard models; 3. The effort and work in labor market could be hard
to monitor appropriately; 4. It is impossible to incorporate the concept of “involuntary
unemployment” into the standard model.

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(2) The total income is just piece rate multiplying the number of tasks, so the relationship
between total income and number of tasks is linear. The higher the piece rate, the higher
the total income given the same number of tasks. Since total income is on the horizontal
axis, a higher piece rate means a flatter line.
For part (a),(b) and (c), see graph below.
(3)(a) Borrowing is positive when energy input is lower than the energy expended in
physical activity and basic body needs. Clearly, there is a limit to how much an individual
can borrow from bodily stores - they will be exhausted at some point, and this will limit the
physical activity that the individual can sustain.
Individual B will have a worse nutritional status. Since storage is costly, what he saves
in good times will be less than what he can use in bad times, which means that his average
nutritional status will be worse than individual A’s. In casual markets, income is usually
quite low that individuals cannot save for bad times (and hence would have to behave more
like individual B). Energy input will be directly related to income, and thus will be uncertain,
which will result in worse nutritional status.
(3)(b) The long-run body weight is the one where energy expenditures equal energy input.
In this case, it is a body mass of 50 kilograms(kg). If body weight starts above 50 kg, then
there will be borrowing from body resources until the person is so exhausted that he loses
enough weight and ended up weighing 50kg. If body weight starts from below this long-run
value, energy will be stored and body weight will increase.
(4)(a) Review section 13.4.1 for detailed discussion. The slope of the capacity curve is the
additional amount of work a worker can perform with one additional unit of income. Suppose
every laborer has the same shape of capacity curve. If the worker aims to maximize the total
income, the capacity curve will determine her labor supply. There is a piece rate at which
the income curve is tangent to the capacity curve. If the piece rate falls a little bit, there
will be a large downwards jump in individual labor supply. As a consequence, aggregate
labor supply will have a gap, and if supply is large relative to demand, some workers will be
unemployed.

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Answer Keys 43
(4)(b) Now, we will assume that there is a small source of non-labor income. The rela-
tionship between total income and capacity is unchanged (it is the dotted line in the graph),
but now wage income is only part of total income, so that for a given wage, work capacity is
slightly higher. In other words, the curve will shift left. Clearly, the new piece rate at which
income is tangent to the capacity curve is lower.
(4)(c) If there is unemployment, then we know that the income line is tangent to the
capacity curve. Recall that the capacity curve as a function of total income is the same. We
have proved in part (b) that the piece rate must fall (hence the slope of the capacity curve
at the equilibrium must be higher). Because we are in the decreasing returns part of the
capacity curve, this means that the total income in part (b) must be lower than that in part
(a).
(4)(d) The comparison in the text is between people who face the same wage rates. When
this is the case, the person with higher nonlabor income will earn more wage income for the
same wage. Because he has other sources of income, he can work more hours at the same
wage. This is different from the cases in this problem.
(5)(a) The employer only cares about expected wages. If he were to hire laborers in
the spot market, his expected wage payments would be 0.5 * $50 + 0.5 * $100 = $75.
The expected wage payments of any contract of the form (w1 , w2 )would be 0.5w1 + 0.5w2 .
Therefore, the set of contracts that are acceptable to the employer are the pairs (w1 , w2 )
such that (w1 + w2 )/2 ≤ 75, which is just (w1 + w2 ) ≤ 150.
(5)(b) The first requirement is just the conclusion of part(a). Now since the worker is
risk-averse, he would want to smooth out the wages from the original distribution, which
means precisely getting more in the bad case (w1 > 50) while getting less in the good case
(w2 < 100).
(5)(c) If the spot wage is $100, then under the long-term contract the worker is receiving
w2 < 100. This gives him an incentive to break the contract and make the extra short-run
gain of ($100 − w2 ).

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(5)(d) If the problem is so serious that whenever the spot market wages is $100, both
the employer and the worker are expecting the worker to runaway from the contract, then
the expected value of the contract in the employer’s perspective is simply w1 > 50. This is
more than what the employer would have paid if he had just looked for a worker on the spot
market, and therefore he will avoid such contracts altogether and simply hire on the spot
market.
(6) For any w ≤ $100, the employee has no incentive not to shirk; since he can always
get a casual job at the wage of $100, he is not afraid of being fired at all. In addition, “not
to shirk” often incurs an extra cost (opportunity cost, perhaps) of effort, say c > 0, so the
employee will only work hard if w − c ≥ $100, which means w would have to be strictly
larger than $100.
Now for the three factors that might affect w:
(a) If alternative uses of the laborer’s time increase in value (c increases), then the wage at
the permanent job will need to be higher in order to prevent shirking.
(b) The higher the likelihood of finding another permanent job, the higher w would have to
be. This is because the possibility of landing another permanent job improves the outside
option of the worker, and hence would drive up the expected payoff in the case where the
worker is fired. In the extreme case where the worker can land another permanent job with
100% probability, no matter how high w is the worker can always shirk as he desires.
(c) Clearly, the higher the casual wage, the higher w needs to be. Reasoning is similar to
that in (b).
(7)(a) Suppose there are u unemployed people. Then the following equation (which de-
scribes the wheat constraint) must hold:
250n + 100u + 200(5000 − n − u) ≤ 1, 000, 000
This yields u ≥ 0.5n, which means that the number of unemployed people must be at least
half as many as the number of rich people in society, or else there wouldn’t be sufficient food
for everyone.
(7)(b) If less than 0.5n people are unemployed, then there will be a wheat shortage. This
will tend to increase wheat prices. The rich will presumably still be able to buy their share
of wheat at the higher prices. However, some of the employed people may find that with
the increased price of wheat, their wages are not enough to pay for their nutritional needs.
Thus, some of them will leave their work, and eventually we will observe a transfer from
private to public employment, but no absolute increase.
(7)(c) Governments may try to redistribute wealth from the rich people to the unemployed,
bringing down n (or at least their wheat consumption) and hence creating space for u to
decrease.

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Answer Keys 45
❈❤❛♣t❡r ✶✹
(1) In informal credit markets, lenders usually charge an interest rate that is above the
opportunity cost. This is partly because repayment of informal loans is uncertain, and
so the interest paid by performing loans must compensate the losses from nonperforming
loans. The difference between the minimum rate at which the lender is willing to lend and
the opportunity cost is called “risk premium”. In the following calculations, p is the risk
premium.
(a) 0.5 ∗ (1.1 + p) + 0.5 ∗ 0 = 1.1 , p = 110%;
(b) 0.5 ∗ (1.1 + p) + 0.5 ∗ 1 = 1.1 , p = 10%;
(c) (1/3) ∗ (1.1 + p) + (1/3) ∗ 1 + (1/3) ∗ 0 = 1.1 , p = 120%;
(d) 0.5 ∗ (1.1 + p) + 0.5 ∗ (0.5 ∗ 0 + 0.5 ∗ 500) = 1.1 , p = 85%.
(2) Read sections 14.3.5 and 14.3.6 about credit rationing; the main idea is that a higher
interest rate would give the borrowers more incentive to default, and the fear of sparking off
a default prevents such actions by the moneylender.
Now consider the example; let l be the size of the loan, then:
The largest loan size that will be offered is $99. For any larger amount, the return in
the formal sector is higher than that in the informal sector. In order for loans in the
$250-300 category to be offered, the rate should compensate for the default risk. That is,
0.7 ∗ l ∗ (1 + r) = 1.1 ∗ l, r = 57%. To amend this example to the more general case, we
would have to allow default rate to increase as the interest rate increases.
(3) See the example in the first part of section 14.2.1. This makes many risky projects
profitable to the borrowers but not for the lenders, and therefore the banks often try to
prevent borrowers from taking up such projects.
(4) See Loan repayment in labor in section 14.4.4..
(5) See Loan repayment in output in section 14.4.4..
(6)(a) Given the price of output and the rate of interest on a loan, a farmer who maximizes
his profit will choose a loan size such that marginal revenue equals marginal cost. Thus, using
the notations in the statement of the problem, M P ∗ p = (1 + i), and hence M P = (1 + i)/p.

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(6)(b) If p∗ and i∗ are the price and interest rate offered by the trader, then any combina-
tion such that M P = (1 + i∗ )/p∗ will induce the farmer to generate the maximum surplus.
By changing i∗ and p∗ , the trader can extract more or less of this surplus. In particular, he
will choose the level such that the farmer gets his opportunity cost.
(7) Yes, there should be a systematic difference in rates between loans that are made for
production, and loans made for consumption. Consumption loans are riskier, since they do
not produce any sort of physical assets that could be seized in the event of a default. In
addition, consumption loans often come about because of an unexpected illness or condition,
and thus have relatively fixed sizes that are not very sensitive to interest rates. In contrast,
working capital loans are more flexible, and the borrower will respond more to the interest
rate so that it can reflect and influence the risk the borrower takes on. These suggest that
rates should be lower for loans made for production purposes.
(8) In theory, there are reasons to argue both ways. Read section 14.5.1. Vertical formal-
informal links for a detailed discussion.
(9) There is a unique lender, so the outside option to the borrower in this case is zero. Say
the loan size is $100. If it is worthwhile not to default today, then the borrower will never
default. For this to be the case, P
300 ≤ ∞ t
t=0 0.5 (300 − 100(1 + i))
300 ≤ 2 ∗ (300 − 100(1 + i))
Thus, the borrower will not default on a $100 loan as long as the interest rate is lower than
50%. Similarly, we can show that for the $500 loan to be repaid, the interest rate must be
non-positive. Thus, we see that the lender will always make the $100 loan, at the maximum
interest rate he can charge: 50%, abd the profit each period is $50.
Now, assume that the lender can always obtain $300 from collateral, which reduces the
borrower’s payoff in the case of default. The table summarizes this problem:
In this case, the lender still makes larger profits by lending $100, and reduces the
borrower’s profit to zero. The lender, on the other hand, is better off.
(10)(a) pS.
(10)(b) The net gain from default is the amount of the loan that the borrower does not pay,
minus the fines and the loss of membership in SelfHelp, which is equal to L(1 + r) − F − pS.

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Answer Keys 47
(10)(c) Assume we have repayment rate on the horizontal axis and the survival probability
on the other. The chances of survival should probably be at zero until repayment rate reaches
a certain level, and then slopes upwards afterwards. Government assistance only comes in
when there is a high rate of defaults, and hence only changes the probability of survival
where the default rate is high. In those cases, higher levels of government assistance will
increase survival probability and shifts the left-hand part of the curve upward.
(10)(d) An individual will decide to default on her loan if the net gain is positive. There
could be a loan size such that if default rates are low, and p is high, L(1 + r) − F − pS < 0 (so
that the individual will repay), but if default rates are high, and the probability of survival
is p′ < p (accounting for government help), then L(1 + r) − F − p′ S > 0 and it is rational to
default on the same loan.
(10)(e) If the government commits to helping SelfHelp in times of trouble, then the prob-
ability of survival will be independent of default behavior (and will be quite high). In this
case, there cannot be two equilibria for the same loan size. If loan size and punishments are
chosen well (such that L(1 + r) − F − pS < 0), this will lead to low default rates.
ps+f
(10)(f ) From L(1 + r) − F − pS < 0 we have L < 1+r
. Clearly, the maximum size of the
loan increases as p increases.
(11)(a) and (b) Read section 14.5.2. for a detailed discussion. For example, group
lending tends to sort individuals by their credit level (since the individual with good credit
will most likely choose another with similar good credit, a kind of information that may
not be available to the lender), and peer monitoring is an extra incentive for borrowers to
repay. Two of the drawbacks include: 1. In situations where one of the members runs into
genuine financial difficulties and must default, the others will be negatively affected as well;
2. The peer pressure may induce individuals to choose overly safe projects (from the society’s
perspective) and generate a suboptimal outcome.
Part (b) is an open-ended question, though it is imaginable that the sequential lending
strategy could potentially lead to a higher repayment rate, since, on one hand, in that case
not only everyone else’s eligibility to take out a loan depends on the repayment of the current
borrower, but there is one (the next borrower in line) that would be particularly concerned
about the current borrower’s repayment and would probably exert some extra pressure. On
the other hand, with simultaneous lending, if the members expect at least one of the other
members to default, then they would all default since they don’t expect to get any future
credit anyway.
❈❤❛♣t❡r ✶✺
(1) Regarding information and correlation, the major problems in agricultural crop insur-
ance are that: 1. It is often very difficult to verify the outcome of the agricultural production,
and 2. Agricultural production are heavily dependent on the weather, and hence the out-
come of the production in a local area is very likely to be highly correlated. The second

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point makes providing such insurance particularly hard, since when the outcome is bad, it is
bad for an enormous number of people, which would require a large amount of payout that
could often bankrupt the insurance company.
With a village council deciding on how to allocate payouts to individuals within the
village, the informational challenge can be addressed to some extent, since information bar-
riers within village is likely to be lower, but the correlation problem is still just as significant
as before, unless the insurance company is able to insure a large number of geographically
diversified villages, and deliver payouts on easily observable factors (such as rainfall) instead
of agricultural outcome itself.
(2)(a) If the events are independent, then the joint probability of any two events is the
product of their own (marginal) probabilities. In particular, q = p2 , r = p(1 − p), and
s = (1 − p)2 .
(2)(b) If we think that the two incomes are positively correlated, then we would expect
the HH and LL outcomes to be more likely than under the independence hypothesis: q > p2
and s > (1 − p)2 . In the extreme event of perfect positive correlation, q + s = 1 (i.e. r = 0).
Negative correlation would be the opposite, with r > p(1 − p), where perfect negative
correlation would imply q = s = 0.
(2)(c) Perfect negative correlation would be most conductive for mutual insurance between
A and B. In this case, their total income is always stable at (H + L). Therefore, they can
arrive at an agreement as to how to divide this total income, and each enjoy the exact same
amount of (risk-free) income in every period.
(3) Review section 15.2. for possible approaches and their limitations.
(4) Many factors would enter the household’s decision as to what assets to use for smooth-
ing. For example, the asset’s value must be rather stable over time, and that it must be
rather easy to trade on the market when necessary. When inflation isn’t a concern, the value
of cash is stable and hence certainly serves as a perfect asset for smoothing consumption.
(5) There are two factors that may affect the viability of bullocks as means of smoothing
consumption. Since farmers are usually subject to village-specific shocks, they need access to
potential buyers that are far enough from their own villages so that the buyers experienced
different shocks. At the same time, to smooth consumption, a trade has to be made, and
high transportation and communication costs will make it less likely for a transaction to take
place. Hence, overall, the first economy seems like a better place for bullocks to be used in
consumption smoothing.
(6)(a) Without insurance, individual farmers are subject to the individual risk of each
project. If they have a menu of options with different risk-return profiles, they will more
likely choose a low-risk option, which will usually be low-return as well. In contrast, the

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Answer Keys 49
availability of insurance reduces the risk to each individual farmer, allowing them to obtain
the average return of the projects. Hence, they are likely to end up choosing a riskier
alternative with higher average return.
(6)(b) If insurance works by redistributing income after each realization of shocks, then
individuals only get a fraction of the increased expected return of adopting a new technique.
Thus, their incentive to adopt such techniques is lower than that if they chose the technique
collectively.
(7) Members of an extended family know more about each other and are more able to
monitor effort and final outcomes than a group of strangers. Thus, extended families alleviate
the informational constraints that plague mutual insurance efforts.
(8) (i) The poor group has more to lose from shirking, which makes them less likely to
be prone to the problem of moral hazard. (ii) By adding a credit component, individuals
know that a high output will on average increase all their future payoffs, while a low output
will reduce them. This increases the individual incentive to exert effort. The insurance
component ensures that this arrangement is preferable to the alternative of self-sufficiency.
(9) Because higher mobility of people would increase the difficulty of enforcements of in-
surances. After all, you can’t enforce anything on a person who you can’t properly monitor
his or her whereabouts. In addition, these often informal contracts are usually set in the
context of a social norm that encourages reciprocity and punishes deviations through social
sanctions such as ostracizing or public rebuke, all of which would be difficult to carry out in
the presence of high mobility of persons.
❈❤❛♣t❡r ✶✻
(1)(a) When a country devalues its currency, it does not alter the international demand
curve. But that international price is now higher in domestic terms, which makes domestic
manufacturers more willing to produce exportable goods. Thus, exports increase because
domestic resources are redirected towards exporting industries. If the country is relatively
small, the international price will not react to this increased production. If it is a large
manufacturer, increased production may reduce the international price, but in general it will
remain higher in domestic terms.
(1)(b) As the last part of the previous answer suggests, the effect of a devaluation on
export earnings measured in foreign currency depends on the price elasticity of international
demand. If the international price is unchanged, then exports of all other countries that
manufacture the given good will be unchanged. Since domestic production of that good
will increase following a devaluation, there will be excess supply. This is where elasticity of
demand plays a crucial role.
If demand is very price elastic, it will take a small change in price to compensate for
the additional production. In this case, earnings in foreign currency will increase. If, on the

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other hand, demand is highly inelastic, it will take a large drop in prices to induce demand
to absorb the increased production. In this case, earnings measured in foreign currency will
go down.
(2)(a) The revenue from adding an extra worker to the computer industry is pc /10, while
the revenue from adding an extra worker to the rice industry is pr /15. If the relative price
of computers to rice were smaller than 2:3, we would have
pc
pr
< 2/3 = 10/15
pc /10 < pr /15
That is, revenue in the computer industry would be less than that in the rice industry. As a
consequence, there would not be any computer production. The same reasoning would show
why a relative price above 2:3 would result in no rice production.
(2)(b) This “knife-edge” behavior follows from the fact that the production possibility
frontier is a straight line in this case. In the Heckscher-Ohlin model, the production possi-
bility frontier is bowed out, which allows a whole range of price ratios to be consistent with
the production of both goods.
(2)(c) The argument in part (a) shows that the “knife-edge” ratio is the ratio of labor
requirement in the computer industry, to the requirement in the rice industry. In the case
of country S, this ratio is 40 : 20 = 2 : 1.
(3) The price ratio 1 : 1 means that computers will be produced in N , and rice in S. Only
labor is a factor of production, so that all revenues are paid to workers. This means that the
wage rate will equal revenue per worker. Thus, wN = $100/10 = $10 and wS = $100/20 = $5.
(4)(a) An increase in the relative price of cars will cause labor and capital to leave the
textile sector and go to the car sector. Since car production is more capital intensive than
textile production, the ratio of labor to capital released by the textile industry will be higher
than that demanded by the car industry. In order for the car industry to absorb labor and
capital in this proportion, the ratio of wages to capital income will need to fall.
(4)(b) If the ratio of capital to wage income goes up, then the capital-intensive industry
will be worse off than the labor-intensive industry. In this example, the car industry will be
worse off.
(4)(c) The initial change that makes car production more profitable than textile pro-
duction (the increase in relative price) endogenously changes factor prices so that textile
production will remain profitable.

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Answer Keys 51
(5) Under the Hecksher-Ohlin model, countries export goods whose production is intensive
in their most abundant factor. For a poor country, that would be a good that is intensive
in unskilled labor. In the H-O model, this happens because it is the way in which countries
maximize their income. Once this income is maximized, however, a strong preference for
goods that are intensive in unskilled labor will tend to reduce their exports, since all else
being equal, domestic consumers will be willing to pay a higher price for them than foreigners.
(6)(a) For a given level of production of bread and wine, each firm has a constant returns
to scale technology available to them. There is only one input, labor, which means that
xw = aw lw and xb = ab lb . Thus, producing one less unit of wine frees up 1/aw units of labor,
which can yield ab units of bread. This amount is fixed, resulting in a straight production
possibilities frontier. See figure below.
(6)(b) In the economy as a whole, shifting one unit of labor from wine production to bread
production reduces wine production for two reasons: there are less workers producing wine,
and those who remain producing wine are less productive. In addition, as bread production
increases, each additional worker becomes more and more productive. This means that
shifting one worker from wine to bread when all resources are in wine will increase bread
production by less than a similar shift when most resources are in bread production. This
leads to an unusual shape of the production possibilities frontier: bowed inward. See figure
below.
(6)(c) Both countries consume goods in fixed proportions, which means that with no trade,
production will be in an internal point on the production possibilities frontier. Under trade,

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a price level that exchanges B units of wine for A units of bread will allow both countries
to reach a higher indifference curve. There are two equilibria of this kind, one for each
specialization pattern. The situation at which each country remains the same as in autarky
is also an equilibrium, as no country has any excess production that it is willing to trade. If
production deviates from this point, it creates an incentive for the other country to change
production in the other direction. In this sense, it is an unstable equilibrium. See figure
below.
❈❤❛♣t❡r ✶✼
(1) Under autarky, a country will in general have a production possibility frontier that
bows outwards. When there are opportunities for international trade, consumption possi-
bilities can be increased. We can see this in an example where a country produces textiles
and cars. Take the point on the production possibility frontier where the marginal rate of
transformation between the two goods is the same as the international price (see the follow-
ing figure). Now, consider what this line tells us. Starting from point A, with production
CA of cars and TA of textiles, international trade allows the country to consume the bundle
of goods represented by point B. Note that at this point, car consumption is higher than
domestic car production would be if all resources were allocated to car production. Essen-
tially, international trade has allowed the country to “produce” cars by exporting TA − TB
units of textiles and importing CB CA units of cars.
Notice that this line lies outside the original production possibility frontier, which
means that trade provides an opportunity for Pareto improvements: for any feasible alloca-

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Answer Keys 53
tion without trade, there is an allocation with trade where consumption of at least one of
the goods is higher (and that of the other good is not lower).
(2)(a) If all individuals have the same holdings of all factors of production, then any policy
that increases total national output will increase all individual’s income. As we saw in
problem 1, opening up to international trade has the (static) effect of expanding production
possibilities. Any aggregate consumption basket that was available under autarky will remain
available with international trade. In other words, aggregate real income is higher, in terms
of every good. Since every individual participates equally in aggregate income, it follows
that they will all be able to afford their autarky consumption levels. Thus, opening up to
trade will lead to a Pareto improvement, as noone is made worse off and, if there is any
trade, at least someone will be made better off.
(2)(b) Opening up to trade may have negative overall effects. Although it may be the best
choice in the short-run, it may have effects on subsequent growth - and therefore on future
generations. An instance of this happens when certain sectors produce external effects that
benefit other sectors of the economy. On their own, these sectors may not have a comparative
advantage, and thus international trade will tend to reduce their size. Because of their
positive externalities, however, this reduced size will be smaller than the social optimum.
As an example, the high-technology sector has an influence on the economy that goes
beyond its own sector. International bans on technology exports, transaction costs, and local
idiosyncracies mean that a domestic technological advance will in general be much better
for local users of that technology than a foreign one. Hence, a country that doesn’t have a
comparative advantage in the technology sector when considered in terms of private profit
may find itself worse off when it opens up to free trade without any sort of protection policy.
(3)(a) To draw indifference curves that reflect preferences for food that grow relatively
weaker as we increase consumption of both commodities, first draw a ray through the origin.
We would expect that along this ray, the further away we move from the origin, the less non-
food consumption an individual will be willing to give up in exchange for food consumption.
Thus, the indifference curves will grow steeper as we move along the line. This is shown in
the first figure, together with budget constraints. Note that because relative prices are fixed,
they all have the same slope.
The second graph plots physical consumption of food and nonfood items as a function
of total income (measured in nonfood units). We can see that nonfood consumption is
growing at a faster rate than food consumption.

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(3)(b) Since prices are fixed, the growth rate in physical consumption is the same as the
growth rate in expenditures. Given that the volume of nonfood items is growing faster than
that of food, it follows that expenditure in nonfood items is also growing faster. Since all
income is consumed, food expenditures must be rising at a slower rate than income (and
nonfood expenditures at a higher rate). What does this imply about food exporters? If
prices stay the same, their size of world income will grow smaller. Thus, they will become
poorer in terms of nonfood items.
(3)(c) From part (b) we’ve seen that exporters of food will find export revenues grow more
slowly than world income, which in a relative term dampens the income growth rate of the
farmers, especially in developed countries where the rest of the society is growing (or has
grown) rapidly into a wealthy condition. As they see their growth lag behind their peers
within the same country, they would demand support from their governments.
(4) Open-ended question; review the text for detailed discussion. Notice the externality
issue we’ve considered in problem 2.
(5) Open-ended question. Read section 17.2.2. More detail, especially the paragraphs
under How tariffs and quotas work and Welfare effects: static and dynamic, for more details.
Your discussion should revolve around the main points mentioned in the problem, namely
the issues of tariff revenue, black markets and bribes for quotas, and the lack of information
that the policymaker may have about the economy.

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Answer Keys 55
(6)(a) First, notice that without a tariff, there can be no domestic production of cement,
so that an excise tax by itself will not produce revenue. A tariff of size t will have varying
revenue depending on its amount:
(i) If t ≤ $0.50/kg, then the domestic price of cement will be such that both industrial and
household construction companies will buy it. As a consequence, total imports will still be
30 million kg a year. But the revenue (in million) will be 30t < 30 ∗ $0.50 = $15. Thus, a
tariff by itself will not yield $20 million.
(ii) If $0.50/kg < t ≤ $3.50/kg, then only industrial construction companies will buy cement,
and import will be 5 million kg a year. The maximum tariff revenue will then be $17.5 million.
(iii) If tariffs are greater than $3.5, then the domestic price of cement will be greater than
$5, and domestic producers will meet the demand, so that tariff revenue will be zero.
(6)(c) A combined tax/tariff policy would work by increasing the domestic price of cement
so as to induce domestic producers to enter the market, and tax them. Various tax/tariff
combinations would do, and we can characterize them as follows. First, revenue will come
from taxes, so that if we denote taxes
 by τ ,

5 + τ ≤ 1.5 + t
5 + τ ≤ 10


5τ ≥ 20
The first condition characterizes tax/tariff policies such that only domestic producers
enter the market. The second condition requires that final prices are such that demand equals
5 million kg. The third condition specifies that the tax should raise the desired revenue. A
possible combination is τ = 4, t = 7.50.
( The general condition is that
τ ∈ [4, 5]
t > τ + 3.5.
(7)(a) See graph below.

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(7)(b) See graph below and notice the sum of the consumer and producer surplus along
with the tariff revenue, is less than the sum under free trade.
(7)(c) The following graph shows what goes on with total surplus when we add a tariff to
a good with perfectly elastic supply. Since the producer price cannot drop, the tariff merely
transfers money from consumers to the government. However, the rise in consumer price
has caused a reduction in trade, and hence prevented potential consumer surplus from being
realized, lowering total welfare of the society.
(7)(d) We will not repeat the previous graph of import supply and demand. We know
that the sum of consumer surplus, producer surplus, and revenue is maximal when tariffs are
zero. However, the government cares only about the sum of revenue and consumer surplus.
Therefore, we will study what goes on with producer surplus. An increase in tariffs reduces
producer price, which results in a decrease in producer surplus. On the other hand, an
import subsidy makes producer prices go up, which increases producers surplus. Note that
this implies that producer surplus is not (graphically) flat when tariffs are around zero. Since
the total is flat (it is maximized), this implies that domestic surplus is growing, and that a
tariff which aims to maximize it will be strictly positive, as shown in the figure.

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Answer Keys 57
(8)(a) A government may choose to protect a sector of the economy where production
shows increasing returns to scale. By imposing tariffs, the government allows a new domestic
industry to capture the domestic market and reach a size such that it will be able to compete
with foreign firms. For the tariff to be efficient, it should be temporary - consumers are paying
a cost as long as protection is in place (since there are potential benefits for them to gain if
foreign producer were allowed to freely compete).
(8)(b) Say there is a pre-determined expiration date for the tariff. When that day comes,
the government will face political pressures to keep the tariffs in place, not only from the
industry, but also from the workers in that sector who may be displaced by opening up to
trade. Of course, there may be some pressure in the opposite direction. But if protected
interest groups are sufficiently strong and concentrated, while those who are hurt are only
hurt by a little and largely unorganized (such as in most cases of tariffs),the government
will not have an incentive to remove the protection. However, if the industry can foresee
this, they will not make the necessary investments to become competitive within the pre-
determined timeline, and the tariff will end up being nothing more than an inefficient transfer
from consumers to the industrialists.
(9) The logic for limiting exports can be seen by the example of a country that is the sole
producer of a good. In this case, it enjoys a monopoly in the world market. We know that
if there were a single firm in charge of producing the good, it would charge a higher price
than a large number of small competitors would. By setting an upper bound on exports at
the monopoly equilibrium level, the government can create a larger domestic profit (which
it may capture as export taxes).
Why do these restrictions usually come from outside the firms? For each individual
firm, there is an incentive to increase production slightly - it will raise its own revenue and
hardly affect market prices. But when all firms act in this way, the price is driven down
to the competitive level. This is the problem faced by every oligopoly: each firm wants to
free-ride on the others, and they often end up at a suboptimal equilibrium.
(10) Open-ended question. Among the many possible reasons, here are a few to con-
sider: 1. Not all citizens in India would benefit from such agricultural liberalization; the
re-distributional effects caused by the increased exchange rate might hurt exports in other

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sectors (or producers who were competing in the domestic market, who would now likely
facing more competition from foreign imports). 2. In countries with a huge population like
India, where some of its population are struggling to gather sufficient foods, the opening up
of exports could increase the domestic prices as well, making those poor people’s lives more
difficult.
(11) Open-ended question. One of the most obvious reasons is that deliberately over-
looking such intellectual property rights issues allows domestic companies and consumers to
experience a higher surplus (at least in the short run); taking advantage of the ideas and
high-tech products from the developed world without paying for them enables the developing
world to develop at a higher rate. On the other hand, to provide such protection would re-
quire a large amount of resources that could have been allocated to other more “productive”
uses (just see how hard it is to enforce intellectual property rights even in the developed
world), and in the short run, the benefits of such actions are mostly captured by foreign
companies and individuals who own the rights, leaving little incentive for the developing
countries to take any action regarding these issues.
(12) Open-ended question. Despite the fact that there are cases where governments ac-
tually did default on their debts, though indeed quite rarely, governments can strategically
manipulate the value of their currencies through methods such as creating unexpected hyper-
inflation to reduce the true value of their debts. In these cases, although technically they
haven’t “defaulted” or gone into bankruptcy, the value of the repayment the lenders got back
from the government is often only a small fraction of what it had been when the lender lent
it to the government. In this sense, involuntary defaults are quite rare (where total debts
of a country exceeds its total asset), but strategic partial defaults are not that uncommon,
and hence lending to governments is not always that wise (not to mention if a government
is indeed deemed to exhibit extremely low risk, the interest rate would most likely be just
as low).
(13) Open-ended question. The essence is that, as long as future credit is valuable to the
borrower, and the gain from running away with the current loan is not too high, there is
potential for such transactions to still exist. The lender would most likely refuse to provide
any future loans once the borrower defaulted or ran away, but in addition, the lender might
also want to get hold of some collateral from the borrower or to keep the loan at a relatively
small size, limiting the gain of the borrower in the case where he or she runs off.
(14)(a) The net return to the government from undertaking these investments is the overall
payoff minus debt service payments. In this case, out of an investment of $10 billion, the
government will receive $2.5 − $2 = $0.5 billion. That is a 5% return on investment, less
than the 10% minimum.
(14)(b) We are assuming that the government only pays if it has returns on its investment,
and that it always pays if it does. Under these assumptions, if outstanding debt service
payments are too high, the government will not invest and thus will not pay back its debt.
If this is the case, debtors may choose to reduce debt service payments, and allow the

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Answer Keys 59
government to partially repay its debt. In this example, the minimum amount of forgiveness,
f , needs to satisfy this equation:
2.5 − (2 − f ) = 1
That is, f = 0.5 billion. If the reduction is lower, the government will not receive the
minimum $1 billion return on its $10 billion investment.
(14)(c) This is related to the theory of land tenancy in the sense that a fixed rent does not
diminish the farmer’s incentive to work hard (since all the additional/marginal gains will be
capture by the farmer), while share cropping distorts this incentive. Forgiving the debt has
the advantage that it doesn’t affect the marginal benefits of a government’s investment, and
hence only the most productive investments will be undertaken. We can see this with an
example. Say an investment of x yields a gross return of R(x). If f is the amount of debt
that was forgiven, then the government will maximize R(x) − x − (2 − f ), which will lead to
the same choice as maximizing R(x) − x, as long as an investment is undertaken, and will
lead to the optimal x∗ such that R′ (x∗ ) = 1.
However, imagine that the debtors try to encourage these investments by contributing
capital k and claiming a share r of the profits. Then the government will solve
max(1 − r)R(x + k) − x
1
which is solved by choosing an investment level such that R′ (x̃ + k) = 1−r > 1, as long as the
total return to the government is more than 10%. In cases where investments are positive,
x̃ + k < x∗ if there are decreasing marginal returns to capital.
(15)(a) Say the loan is made with no conditions. If it is used as investment, then out of the
$2.5 billion it will only get to keep $0.2 billion ($2 billion go to debt service payments, $0.3
billion to the international organization). This is not enough to induce the government to
invest it voluntarily. However, conditioning the loan on its use in these projects will induce
the government to accept it, as it still has a positive payoff.
(15)(b) If the ongoing debt service were $2.5 billion (instead of $2 billion), then the return
on the investment would not cover the sum of debt service and payment to the international
organization. As a result, some debt forgiveness will be necessary for the government to
accept the loan.
❈❤❛♣t❡r ✶✽
(1) Despite the potential overall gain that could stem from free trade, there are usually
groups that would experience losses from less protection. Although the gains, in theory,
should outweigh the losses, it is very hard to precisely identify the two groups of people, and
hence swift and accurate compensation is rarely possible. Moreover, it is possible that such
retaliatory protection is put in place in the hope of providing incentive for and pushing the
other country to remove its trade barriers, even at the cost of the country’s own short-run
welfare.

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(2) Each of the known x winners will be in favor of the policy. For the remaining 100 − x
people, the probability of being a winner is (60 − x)/(100 − x) and the probability of being
a loser is 40/(100 − x) Thus, their expected return from the policy is:
60−x 40
100 100−x − 80 100−x = 2800−100x
100−x
Note that all people whose outcome is uncertain will vote in the same way. If x < 28,
then the expected return from the reform will be positive. If, instead, x > 28 but is not
enough to attain a majority, then the reform will not pass. In other words: for an efficient
reform to occur, either most of the winners should be known (so that they are a majority),
or they should not be known at all (so that every one has the expectation that they could
become a winner).
(3) Read sections 18.3.3. and 18.3.4. for detailed discussion. For example, for actual
Pareto improvements to be more likely to occur, the two countries should be similar in the
sense that they their trade are in similar products, and that the factors of production (along
with the proportion of factors used in the production) are close to each other. Moreover,
when there is monopolistic power in one of the countries, opening up trade would almost
always hurt the monopoly and hence prevent a Pareto improvement.
(4) In the case of Blanco and Tinto, there is no change in production patterns - both
countries are completely specialized. Thus, if all factors of production were owned equally,
all real incomes would rise and no one would be worse off under free trade. However, if
factor inputs are held unequally, some people will experience a larger rise in income than the
others, and this may lead to price changes that causes the real income of the latter group to
fall (in terms of the domestic good).
(5) Opening up to trade may lead to losses in certain sectors of the economy - for example,
in the Hecksher-Olin model, owners of factors of production that are used intensively in the
imported good are hurt by free trade. One way for free trade to be acceptable is if the
winners compensate the losers, and a common way to achieve this is by taxing the gainers.
In a society where the tax system is not effective, it would be hard to redistribute the gains,
and hence a move to free trade will be much harder due to the fiercer opposition from those
who might lose.
(6) Imposing tough environmental standards usually serves as a non-tariff barrier to im-
ports from developing countries. This protects domestic producers from potential competi-
tion. Thus, environmentalists and trade protectionists may favor similar policies.
(7)(a) In this world, a single group of size 5 maximizes income.
(7)(b) Two groups, one of size 3 and the other of size 2. The group of three would achieve
the most average income, and hence any group that is smaller than 3 would try to (and would
successfully) lure in other members to form a group of 3; once the group reached a size of
3, it would refuse to take in anymore members, and the rest of the two, after comparing
between $100 and $125, would choose to form a group of 2 themselves.

lOMoARcPSD|30183549
Answer Keys 61
(7)(c) The answers are different because adding two people to a group of three reduces
its average income, though the total income is higher. As argued in part (b), if its members
have to share the final output equally, once a group of three is formed it has no incentive to
allow more people in.
However, since total income is maximized with one single group of 5, it is possible to
attain this socially optimal outcome if income is allowed to differ among group members.
For instance, everyone would be better off under the following conditions: out of the final
$900, the three original members get $210 each, and the two new members get $135. If
there is a way for all parties to commit to this agreement - if the new members can credibly
promise not to demand equal sharing, for instance - then the 5 person group is feasible, and
every one will be better off than in the 3 and 2 alternative.
✲❊◆❉✲

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Introduction to Economics (University of Delhi)

Studocu is not sponsored or endorsed by any college or university

Sketches of Answers to Problems

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(2)(d) Please appreciate the beauty of the equations.

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(5)(b) At k = 2, total output is y = 1. So the ratio of capital to output is 2. At k = 6,

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(2)(a) * This part uses Calculus. Suppose that output Y is a constant-returns-to-scale

(3) Direct foreign investment is typically a long-term investment. A production plant, or

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(7) Open-ended question.

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which is clearly decreasing as Xi increases.

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(5)(a) See Figure 5.3 for an example.

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(6) Overoptimistic entrepreneurs systematically overestimate the amount of profits from a

(7) Open-ended question. See problem 5 for inspiration.

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(8)(d) Again consider

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(1) Read the discussion at the beginning of the chapter.

(2)(a) In any one year, half the people

(2)(b) See solution to part(c), a generalization of part(b).

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(8)(a) The beginning income distribution is given by

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(9)(c) False. Consider transfers on the same side of the mean.

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Similarly, we can apply the definition of the coefficient of variation:

Plugging in the numbers, we get

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(5)(b) Read the Paukert and Ahluwalia studies in this chapter.

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(6)(d) If all wages and savings rates are equal, then

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(1) Open-ended question.

(2) Open-ended question. International poverty calculation, by definition, is hard to incor-

(3)(a) See the first two examples in Section 8.2.2.

(3)(d) Indeed. See example 3 in Section 8.2.2.

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(1) Consider the following hypothetical example:

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(3) Open-ended question. Read section 9.3 for guidance.

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