McGill University

Department of Economics

Economic Development I

Old Final Examination

Instructor: Eesha Sen Choudhury

Duration 3 hours

Student Name:___________________________________________________
(Last Name) (First Name)

Student ID #__________________________

Instructions:
a) Clearly print your name on this page and the on the top margin in each page.
b) Answer all questions.
c) Answer in non-erasable ink, not pencil.
d) Only non-programmable calculators and Translation dictionaries are permitted.
No other exam aids are allowed.
e) Cell phones and other electronic devices are not permitted.
f) Round answers to two decimal points.

Part A ---------------------/20 points

Part B----------------------/30 points
Part C----------------------/20 points
Part D----------------------/30 points

Finalterm Grade------------/100 points

 Econ 313-001 Final Exam

Part A
Evaluate the following statements indicating whether they are true, false, or uncertain and
why. Make sure that you indicate how the statement should be qualified if it needs to be
qualified. Please answer 4 out of 6 questions in this section. Each question is worth 5
points. (Indicate clearly which question you are answering) (Grade distribution = 0.5 + 4.5
for the explanation)

1. The urban gigantism problem is solely created by the large population growth in
developing countries.

False. The urban gigantism is caused by many factors other than the large
population growth. Rural-urban migration is a major influence on growth of
large urban centers. So are agglomeration economies in both industrial sector
and in the provision of social, health and other services. Finally, cities are seats
of governments, company head offices etc. and that also results in many
activities that support and depend on such facilities. Students can cite one or
all of the following reasons: hub and spoke transportation system, effects from
import substitution policies, first city bias, advantage from political favors.

2. The Solow model it takes into account the spillover effects that investment in capital,
may have on the economy and hence is characterized by constant returns to scale.

False. A spillover effect is a positive externality that warrants increasing

returns to scale and increasing returns to capital in models like the Romer
model. The Solow model assumes constant returns to scale, whereby a
percentage increase in the labor or capital (these being the only two factors of
production), results in a proportional increase in output. Since, there exists no
additional percentage increase in output over and above that warranted by the
percentage increase in the inputs, it is clear that there are no spillover effects.
Further, the Solow model assumes exogenous technology, while the existence
of techonological spillovers are the source of the endogeniety in technology in
models like the Romer model.

3. The poor incentive structure of sharecropping is itself a reason for inefficiency.

True. Sharecropping refers to a system of sharing the output in some pre-

determined proportion with the landlord on whose land the sharecropper
might be operating. The sharecropper therefore decides on his optimal
labour allocation LS, at the equality between a fraction Υ of the value of his
marginal product (price * MPL) and the nominal wage, which is the
opportunity cost of working on the farm. This optimal level of labour effort
thus determined, is lower than the level of labour effort Lf determined at
the competitive equilibrium of nominal wage equal to the marginal
product, since 0 < Υ<1. Thus, given the poor incentive structure of

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 Econ 313-001 Final Exam

sharecropper, which is Υ of the value of his marginal product, the optimal

level of labour effort, LS, is less than efficient.

Incentives under Sharecropping

Value per unit of labor

VMPL
ɤVMPL

Wa

Ls Lf
Labor
18

4. The best way to reduce inequality in developing economies is through the use of
progressive income taxes. This way, the Gini coefficient will be decreased and the
welfare of the economy will increase.

False / Uncertain. Use of progressive taxes alone do not ensure reduction

of inequality, unless accompanied by income transfers. Progressive taxes
and income transfers is to reduce vertical inequality, by reducing the
disposable income and purchasing power of the economically rich and
enhancing disposable income and purchasing power of the poor.

Given the welfare function, W = W(Y, P, I), the implementation of

Progressive taxes alone, reduces inequality and the Gini coefficient, but
reduces income as well. Since welfare is negatively related to inequality but
positively to income, the net impact of welfare cannot be determined.
Therefore, implementation of progressive taxes alone may be inequality
reducing but not necessarily welfare enhancing.

5. The difference between the modern-sector enrichment growth typology and the
traditional-sector enrichment growth typology is reflected in the respective shifts in
the representative Lorenz curves.

True. The modern-sector enrichment growth typology refers to a situation

where the proportion of the population in the rural and the urban sector
remain constant, though the wage rate in the urban sector increases. Thus
a constant proportion of the population gets richer. The Lorenze curve
shifts outwards, revealing growing inequality. (Graph required)

The traditional-sector enrichment growth typology refers to a situation

where the proportion of the population in the rural and the urban sector
remain constant, though the wage rate in the agricultural sector increases.
Thus a constant poorer proportion of the population gets richer. The
Lorenze curve shifts inwards, revealing reducing inequality. (Graph
required)

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 Econ 313-001 Final Exam

6. Banning child labor is unambiguously beneficial for everybody.

False. The source of the incidence of child labor lies in poverty and low
income levels, such that families are unable to sustain themselves without the
income from child labor. In fact, the number of children desired by such
families, in part is determined by the requirement for a large number of
working hands apart from of course old age security. The idea of banning
child labor arises from the fact that such children engaged in jobs rather than
being sent to school produces, under-productive individuals who have been
under-invested upon in terms of education and health. This therefore has an
impact on their long-term income levels and sustained levels of poverty. Over
and above much of the work environment that children are exposed to are
either abusive, or detrimental to their health.

Banning child labor is however, not unambiguously beneficial. Since child

labor is sourced in necessity as outlined above, banning child labor might
serve to remove children from work in sectors under formal vigilance to illegal
or informal sectors, where incidence of abuse etc. might be much higher.

Part B
Question 1

Roberto lives in rural Venezuela and is finishing primary school. Roberto is deciding
whether or not to go to secondary school. Roberto, like everyone else, lives only for two
periods after primary school. In the first period, he could work on his family’s farm
(without secondary school) for a salary of 300,000 Venezuelan Bolivars if crops were good
or 100,000 Bolivars if crops were bad (Note, crops are good with 50% probability, and
crops are bad with 50% probability).
Or, instead, Roberto could go to secondary school. If Roberto does go to secondary school
in the first period, he’ll have to pay 60,000 Bolivars in fees (tuition and books) but he also
receives 20,000 Bolivars from waiting in a restaurant after school. In the second period, had
he not gone to secondary school, Roberto would continue to work on the family farm and
earn a salary of 300,000 Bolivars if crops were good or 100,000 Bolivars if crops were bad
(Note, crops are good with 50% probability, and crops are bad with 50% probability). With
a secondary school degree in the first period, Roberto would earn 500,000 Bolivars (for
sure) in the second period. Assume that the rate of interest at which Roberto can borrow or
lend money is i.

a) What are Roberto’s costs (direct and indirect) of going to secondary school? [1
point]

b. Secondary School No Secondary School

- 60,000 300,000 (0.5) + 100,000 (0.5) = 200,000
20,000

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 Econ 313-001 Final Exam

500,000 300,000 (0.5) + 100,000 (0.5) = 200,000

Direct costs = 60,000 paid as fees.

Indirect costs = 200,000 in the first year and 200,000 in the second year
Or, write as
Direct costs = 60,000
Indirect cost = 200,000 + [200,000 / (1+i)]

b) What are Roberto’s benefits of going to secondary school? [1 point]

20, 000 in the first year
500,000 in the second year

Or, write as
20,000 +[500,000 / (1+i)]

c) What are, the expected present value benefits and expected present value costs of
going to secondary costs? Based on your calculations, under what conditions will
Roberto go to secondary school? [4 points]

Expected present value of benefits = 20,000 +[500,000 / (1+i)]

Expected present value of costs = 260,000 + [200,000 / (1+i)]

Roberto goes to school if

Expected present value of benefits > Expected present value of costs

20,000 +[500,000 / (1+i)] > 260,000 + [200,000 / (1+i)]

[300,000 / (1+i)] > 240,000

0.25 > i

d) Recall that the internal rate of return to education is the interest rate i=r that makes the
expected prevent value benefits equal to the expected present value costs. Calculate r. [3
points]

[300,000 / (1+r)] = 240,000

30/ 24 = 1+ r
5/ 4 = 1+r
r = 25%

e) Returning to your answer in c), explain what would happen to Roberto’s decision if the
rate of interest increased? [2 points]

If i > r, then Expected present value of costs > Expected present value of
benefits
So, Roberto chooses not to go to secondary school

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 Econ 313-001 Final Exam

f) Roberto learned how to read and write in primary school. What, if anything, might
you recommend to education policy makers in Venezuela in order to increase
Roberto’s productivity on the farm? [4 points]

Training in usage of methods for technological improvement in agriculture –

HYV seeds, fertilizers, pesticides etc. to increase productivity of land,
vocational training, training in accounting methods etc.

Question 2

Two rural individuals Matyás and Toka are contemplating leaving their village for a
nearby town. Given that Matyás has a secondary school certificate, she has a higher
probability of obtaining an urban sector job than Toka, who is a primary school drop out.
If they remain in the village and work on their family farms, they earn $200 each per year
if the yield is high and $100 per year if the yield is low. The yield will be high with
probability 0.5 and low with probability 0.5. Alternatively both these individuals can
choose to migrate to town, in which case they each expect to find a formal or informal
sector job, paying the following earnings according to the given probabilities.

Year 1 Year 2 Year 3

Formal Informal Formal Informal Formal Informal
Sector Sector Sector Sector Sector Sector
Matyás $400 (0.4) $200 (0.6) $400 (0.5) $200 (0.5) $500 (0.6) $300 (0.4)
Toka $200 (0.2) $100 (0.8) $200 (0.4) $200 (0.6) $300 (0.5) $300 (0.5)

(a) According to the Harris-Todaro model, on a one-year time horizon, which

individual will migrate? [2 points]
Farm - expected income in 1 year:
Matyas = (0.5 * 200) + (0.5 * 100) = $150
Toka = (0.5 * 200) + (0.5 * 100) = $150

Town - expected income in 1 year:

Matyas = (0.4 * 400) + (0.6 * 200) = $280
Toka = (0.2 * 200) + (0.8 * 100) = $120

Matyas migrates to town. Toka does not.

(b) On the three-year time horizon, which individual(s) will migrate? (Assume the
rate of interest at which both can borrow or lend money is i = 5%) [5 points]
Farm - expected income over a 3 year horizon with i = 5% :

Matyas = 150 + [ 150 / (1+i) ] + [ 150 / (1+i) 2 ] = $ 428.91

Toka = 150 + [ 150 / (1+i) ] + [ 150 / (1+i) 2 ] = $ 428.91

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 Econ 313-001 Final Exam

Town - expected income over a 3 year horizon with i = 5% :

Matyas = 280 + [ 300 / (1+i) ] + [ 420 / (1+i) 2 ] = $ 946.67

Toka = 120 + [ 200 / (1+i) ] + [ 300 / (1+i) 2 ] = $ 582.59 approx.

Both Matyas and Toka migrate to town.

(c) Assume a one-year time horizon. Suppose now that there is a traditional family
support payment of $40 that all urban migrants must pay yearly to their relatives
back in the village. At the same time, each bears a ‘psychological cost’ associated
with moving to the city. Such a cost is $25 for Matyás and $15 for Toka. Again,
according to the Harris-Todaro model, which farmer will migrate to town? [5
points]
Town - expected income in 1 year:

Matyas = 280 – [ 40 + 25 ] = $ 215

Toka = 120 – [ 40 + 15 ] = $ 65

Matyas migrates. Toka does not.

(d) Assume a one-year time horizon, Still maintaining the ‘psychological’ costs
associated with moving to the city, suppose now that all formal jobs also come
with medical benefits, which are worth $30 a year, in additional to the wage.
Informal sector jobs do not carry any such benefits. According to the Harris-
Todaro model once again, which individuals will migrate to town? [3 points]
Town - expected income in 1 year:

Matyas = (0.4 * 430) + (0.6 * 200) – 25 = $ 267

Toka = (0.2 * 230) + (0.8 * 100) – 15 = $ 111

Matyas migrates. Toka does not.

Part C
Common Essay
The Existence of an Informal Sector: Good or Bad?

The informal sector is becoming an ever-larger part of the urban economy. Just as much as
some benefits accrue to the individuals belonging to the informal sector, there are benefits
that accrue to the formal sector as a result of the existence of the informal sector as well. On

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 Econ 313-001 Final Exam

the other hand, duality, inequality and urban poverty also result from the existence of the
informal sector. Distinguish between the urban formal and informal sectors, and discuss
both the positive and the negative aspects of the informal urban labor market.

Write an essay, to distinguish between the urban formal and informal sectors, and discuss
both the positive and the negative aspects of the informal urban labor market

1. The informal sector is that part of the urban economy of LDCs characterized
by small competitive individual or family firms, petty retail trade and services,
labor intensive methods, free entry and market determined factor and product
prices, It provides a major source of urban employment and economic activity
even as the income is usually not reported for tax purposes while the jobs do
not come with the formal sector benefits like employment insurance etc. The
formal sector on the other hand, consists of large firms, unionized labor, an
oligopolistic set up of the product market etc.

Positive and negative aspects of Informal labour market.

• The informal sector provides cheap inputs to the formal sector. Depends on the
growth of the formal sector for a good proportion of its income.

• The informal sector allows excess labour to escape from the extreme rural poverty
and underemployment.
• Informal sector incomes have remained persistently higher than those in the
poorest rural regions despite continued flow of rural-urban migration.
• The informal sector generates surpluses even in a hostile environment that denies
it access to the advantages offered to the formal sector, such as credit, foreign
exchange and tax concessions.
• Due to low capital intensity, only a fraction of the capital requirement suffices for
the informal sector, but offers considerable savings to developing economies.
• Informal sector generates demand for semi-skilled and unskilled labour whose
absorption in the formal sector is improbable.
• The informal sector is more likely to adopt appropriate technologies and make use
of local resources, allowing for a more efficient allocation.
• The formal sector is generally dominated by men. Consequently, women
represent the bulk of the labour supply in the informal sector.
• Work at low wages at unstable jobs with no employee or social security. Thus a
rising proportion of urban households headed by women tend to be poorer,
experience tighter resource constraints and retain relatively high fertility rates.
• Most institutional credit is still channelized through formal-sector agencies as a
result of which women generally find themselves ineligible for even small loans.
• Legalization and economic promotion of informal-sector activities could improve
women’s financial flexibility and productivity of their ventures. To reap these
benefits governments must repeal laws that restrict women’s right to hold
property etc., conduct financial transactions, or limit their fertility.

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 Econ 313-001 Final Exam

Part D

Please answer two questions out of the following three

1. [15 points] The Big Push model illustrates alternative cases where the economy can
reach equilibrium with a higher level of total output with coordinated efforts by
modern firms and cases where such an outcome is impossible despite such efforts.
Explain with a graph.
(Graph + Explanation = 5 + 10. 10 marks for explanation to divided as 3 + 4 +
3 for explanations on W1, W2 and W3)
The assumptions are required as the graph is drawn.

The entry decisions of the modern firms are to decided. There are three cases
with three wage levels W1, W2 and W3.
With W1, revenues expected to be earned by the modern firm is greater than
its costs. Therefore, the modern firm enters the sector of production
concerned. However since the sectors are all symmetric, the remaining
modern firms enter the remaining (n-1) sectors as well. By creating demand
for each others’ goods, the modern firms help each other expand production
till full employment is reached in all the sectors.

With W2, Revenues are lower than costs. Therefore modern firms incur a
loss with entry. There can be two alternatives here. First, each modern firm
enters incurring the initial loss, ensured of the fact that a similar decision by
the other modern firms will create an expansion of production for all the
firms whereby full-employment output will be reached. Revenues > Costs at
this level of output, and so each modern firm will earn a profit in the long
run. However, a cooperative effort is required from all modern firms in a
decision to enter so that each will be ultimately earn a profit. With failure to
coordinate, this will be a loss making venture to any individual modern firm.
Second, there is coordination failure, such that no single modern firm will
enter given that he is not ensured of a similar decision by the other firms. In
this case, no modern firm chooses to enter a given sector. And production in
all the sectors continues with traditional firms.

With W3, revenues > costs even at full employment output. Therefore,
modern firms cannot expect to earn profits even in the long - run. Thus no
modern firm decides to enter and production continues with traditional
firms.

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 Econ 313-001 Final Exam

The Big Push

W3

Production function in the W2 W1

Q Modern sector

B
Q2

Production function in the

A Traditional sector
Q1

O
F L/N L

11

2. [15 points] How does the microeconomic theory of fertility relate to the theory of
consumer choice? Do you think that economic incentives and disincentives influence
family seize decisions? Explain your answer, specifying some examples of such
incentives and disincentives. (Graph + Explanation = 5 + 10; The 10 marks for
explanation.)

Diagram. The consumer theory assumes that an individual with a given set of
preferences tries to maximize the satisfaction derived from consuming these
goods subject to a budget constraint. In the fertility analysis, children are
considered as a special kind of assumption, so that fertility becomes a
rational economic response to the consumer’s demand for children relative to
other goods. The demand function for a child, defines the demand for an
additional, surviving child. If the social custom in an economy defines a
certain usual number of children a family has, then an additional child
defines a the demand for a child beyond this number. The requirement for
the surviving child accounts for a high incidence of child mortality.

Cd = f(Y, Pc, Px, tx), x = 1,………n ;

δCd / δY > 0, δCd / δ Pc < 0, δCd / δ Px > 0, δCd / δ tx < 0.

Price of a child is defined as the ‘opportunity cost of the mother’s time minus
the benefits from income from child labor and old age security. So, an
increase in income for the mother increases the opportunity cost of the
mother’s time, but at the same time increases the price of a child (Budget line
CD). There are thus two effects that come into play at once - the income and
the price effects. The income effect increases the demand for children
assuming children to be normal goods. The price effect reduces the demand
for children given that households substitute away from children to the
composite good as a result of an increase in the relative price of children. If
the price effect is stronger than the income effect, then the net effect is to

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 Econ 313-001 Final Exam

demand for children to fall (Equilibrium at point ‘g’ compared to initial

equilibrium at point ‘f’).

(Straight from the lecture slides)

Microeconomic Theory of Fertility

Goods consumed by parents (GP)

c
a’

g
G3 h
a I4
I3
G2 f
G1 e
I2
I1

O
c1 c2 c3 c4 b” d b b’

Number of children desired (Cd) 20

2. [15 points] The initial assumption of full employment in the rural and urban sectors
need to broken down in the Harris-Todaro model, as soon as the assumption of
fixed wages in the manufacturing sector is introduced. Why? How does the economy
reach equilibrium thereafter? Explain with a graph.
(Graph + Explanation = 5 + 10; The 10 marks for explanation to be divided
as 5 + 5 for the two questions.)

Use the graph/graphs (Students can easily incorporate all three graphs in
one). The assumption of full-employment necessitates the assumption of
perfect flexibility of wages and prices, so that an excess supply or excess
demand for labor is erased by a corresponding fall or rise in wages. As soon
as the wages in the manufacturing sector is fixed at a level higher than the
previous equilibrium level, the corresponding level of employment in the
manufacturing sector gets fixed as well. In this situation, the wage is not
allowed to fall in the face of any prevailing unemployment. Forcing full-
employment in the economy as a whole would require the rest of the labor
force to be employed in the agricultural sector, at a wage much lower than
the that prevailing in the manufacturing sector. This is economically
unreasonable. Laborers earning a lower wage in the agricultural sector and
capable of earning a higher wage in the manufacturing sector, have economic
incentives to migrate and thus should choose to migrate. To incorporate this
aspect the qq’ curve is used. This is a locus of points that are combinations of
the expected wages in the manufacturing sector and the total labor available
in the urban sector. The economy reaches equilibrium, at the point where the
actual wages in the agricultural sector equals the expected wages in the
manufacturing sector. The laborer for whom this condition holds true, will
remain indifferent between remaining in the agricultural sector and
migrating to the manufacturing sector.

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 Econ 313-001 Final Exam

A M

Manufacturing wage rate

Agricultural wage rate
Labor unemployed

Wages fall

E
WA* WM*
Wages rise
A’
M’
Labor unemployed

OA OM
LA1 LM2 LA* LM* LA2 LM1

A M A M

Manufacturing wage rate

Manufacturing wage rate

Agricultural wage rate

Agricultural wage rate

q’
WM WM
Unexplainable
equilibrium
wage differential
Z
WA
q E
WA* WM*
WA** A’ WA** A’
M’ M’

OA OM OA OM
LM LA LA* LM* LM
Urban employment
LUS

12