McGill University

Department of Economics
Economic Development I Section 1
Sample Midterm
Duration 90 minutes
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 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 I ----------------------/40 points

Part II----------------------/30 points
Part III---------------------/15 points
Part IV---------------------/15 points
Midterm Grade------------/100 points

Econ 313 Section 1 Sample Midterm

Part I
Answer all questions. Unless asked differently in a specific question, please respond as
follows. Please state whether the statement is true as written and explain why. Use graphs
and equations if they would help your arguments. Each question is worth 8 points.
a) Women and children, bear the highest incidence of poverty in the developing
economies.
True. (Straight from the lecture 8)
b) Per capita income has serious limitations as a measure of international comparisons of
economic development.
True. Per capita income numbers do not take into account much of non market
production, externalities such as pollution, sources of satisfaction from nonmarket activities, direct evidence of well-being such as higher life expectancy,
better educational attainment, gender equality etc. Second, per capita income is
an average number. Like all other average it assumes that every individual earns
an equal amount of income, which is incorrect. The measures of unequal
distribution of income like the Lorenz curve and the Gini coefficient compensate
for such deficiency. Unlike economic growth whose emphasis is on the growth of
income, the requirements of economic development has been specified by
Amartya Sen, in his definition of the Capabilities approach. According to this
definition, the extent of development is found by the freedom that a person has in
terms of the choice of functionings, given his personal features (conversion of
characteristics into functionings), and his command over commodities. Therefore it is
no longer merely income, nor the actual command over commodities that is sufficient.
Development lies in the extent to which an individual is allowed to exercise freedom in
the use of the commodities in his command, given his personal nature. The best
formalization in terms of a measure of development is the HDI which weighs at 1/3
weight, the income index, a life expectancy index and education index
c) An decrease in the rate of savings in the Solow model, results in a decrease in the
rates of growth of output per capita, capital per capita and total output.
False. A decrease in the rate of savings, shifts the saving curve downwards, such that the
intersection between this new savings curve and the line of depreciation occurs to the left
of the initial intersection. This new intersection determines the new steady state with y =
y** and k = k**, where y** < y* and k** < k*. At this new steady state, since change in
k and y are 0 each, the rate of growth of y and the rate of growth of k must be zero as
2

well. Moreover, since k* = K/L, therefore if rate of growth of labor = n, and thus change
in labor = nL, change in K must equal nK as well. But if both K and L change by n,
then given CRS, Y must change by n. Therefore the rate of growth of Y, viz. (change in
Y) / Y = n. Since the rates of growth of the per capita variables were zero in the old
steady state and the rates of growth of the aggregate variable were n, they have not
changed. (diagram solicited)
d) According to the big-push model, if there are problems of coordination of economic
activity an economy must remain traditional forever.
Uncertain.
Draw the diagram is drawn. The entry decisions of the modern firms are 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.
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.
In the case of coordination failure, 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. The economy in this case remains traditional as well. However,
we cannot attribute it to a coordination failure, because the decision not
to enter the market undertaken by each modern firm, is independent of
3

the decision of the other modern firms. The actions not being
complementary, the issue of coordination or its failure does not arise.
e) In the Lewis Model, the supply curve of labor in the manufacturing sector is infinitely
elastic.

False/uncertain (depending on how one has written the answer). As long as

there is a pool of surplus labor in the agricultural sector, the
subsistence wage, Ws, in the agricultural sector is determined by the
average product. The manufacturing sector needs to set a wage level
Wm > Ws to be able to draw surplus labor from the agricultural sector
continually at Wm and to put them to productive use. Therefore, as
long as the pool of surplus labor exists in the agricultural sector, the
manufacturing does not need to raise the wage level above Wm to
draw labot such that MPl = Wm. Therefore, the labor supply curve in
the manufacturing sector is horizontal at Wm and thus infinitely
elastic. (diagram solicited)

Part II
Question 1
Suppose that there are two industries in a Romer economy that each
produce output according to the following:
Y1 10 K 10.4 L10.6 K 0.2 and
Industry #1:
Y2 10 K 20.4 L02.6 K 0.2
Industry #2:
Where Y1 and Y2 denote each industrys output, K1 and K2 is each
industrys capital stock and L1 and L2 is each industrys labor force.
K denotes economy-wide capital stock that embodies a particular
technology.
We assume that each industry makes its decisions
holding K fixed.
a) Suppose both industries are identical such that K1=K2= K and
L1=L2=L. Furthermore, suppose that K=100 and L=25, while
K 200 . Calculate Y1 and Y2 and Y Y1 Y2 .

Econ 313 Section 1 Sample Midterm

b) Suppose that each firm has doubled its input, then economy
wide capital is increased. What is K now? What does this
imply?
c) Given your answer in b), what happens to economy wide output
when each industry doubles its inputs? Calculate Y Y1 Y2 and
interpret your results.
a)

Y1= Y2= 1903.7

Ybar = 3807.308

b)

K 400

c)
Y 8746.897

The economy has more than doubled its output by

doubling its inputs. There the economy has
increasing returns to scale.
Question 2
Explain the limitations of using market exchange rates in comparing incomes across
countries. Why is the purchasing parity measure, superior to the exchange rate based
measure?
For the following data, calculate the per capita income of Country A in US dollars using
both the exchange rate based method and the purchasing power parity measure. Both
countries produce only cars and shoes. The exchange rate is $1 = 6 units of currency in
Country A (which is Dinars).

Country A
US

Production of
Cars
Shoes
100
1000
1400
300

Prices
Of Cars
1000 Dinars
200 Dollars

Of Shoes
10 Dinars
10 Dollars

Population
200
300

Market exchange rates reflect the demand and supply of foreign exchange.
These in turn reflect two broad categories of things. First, exports result in
supply of foreign exchange and imports result in demand for foreign exchange.
5

Notice that all goods and services are not tradable; while trade might equate
more or less equate the price of tradables, the prices of nontradables are not
equalized and they reflect the costs of producing them in each country. Services
in particular would be cheaper in poor countries since labor in those countries is
cheaper. Thus exchange rates do not reflect differences in costs associated with
different prices of nontradables.
Second, countries that are continuous recipients of capital from others have an
increase in the supply of foreign exchange compared to those that do not;
therefore they would have their exchange rates higher than what they would
have been in the absence of such capital movements.
Third, exchange rates are very volatile, particularly with respect to changes in
capital movements. It is possible for a country to have the consumption of its
individuals virtually unchanged in a period when exchange rates undergo
massive changes.
Thus incomes compared using exchange rates fail to reflect standards of living.
A purchasing power parity measure values the output in each country using a
common set of prices and thus eliminates the distortion caused by differences in
prices of non tradables. It also abstracts from volatility of exchange rates. Thus
it is a better measure of the well being of a nation compared to one based on
market exchange rates.
Total Income of exotica in Dinars = 1001000 +100010 = 110,000.
Per capita income in Dinars = 110,000200 = 550
Exchange rate based PCI in dollars = 5506 =91.67
Total Income using Purchasing Power Parity in dollars = 100200 + 100010 =
30,000
Per Capital income using PPP in dollars = 30,000200 = 150.

Part III
Write short notes on each of the following topics. Each question is worth 3% of this
examination.

a) Increasing returns to scale

Increasing returns to scale refers to a situation where a percentage
increase in all the factors of production (like labor and capital) results
in a greater than proportionate increase in output. For example, if the
production function is defined such that the two factors of production
6

used are labor and capital, then a 10% increase in labor and capital
will increase the output by more than 10%, other things remaining
constant.
b) Technical spillover
c) Steady State
The Steady State in the Solow Model is defined as the long-run
equilibrium reached in an economy at which the output and capital per
worker are both constant over time. The steady state condition is given
by s*f(k) = (d+n) k*, where k* is that unique level of capital per capita at
which the steady has been reached. (Define the other variables as well)
Given that the savings s*f(k), is exactly equal to the cost of
compensation (d+n) k*, there is no additional savings left to contribute to
an additional amount of capital per person in the next period. Thus,
change in capital per capita is zero once the steady state has been
reached.
d) Coordination failure
A situation in which activities beneficial to two or more selfinterested parties, do not take place because even though their actions
are complementary, they fail to put in consorted effort by means of
cooperation. In such cases a third party which is most often the
government, needs to intervene to coordinate actions. Examples could
include the Kremers O Ring, the Multiple equilibria or the Big push
model.(Diagram solicited).
d) International Poverty line
The International Poverty Line is the monetary threshold under which
an individual is considered to be living in poverty. It is calculated by
taking the poverty threshold of each country, given the minimum
value of the goods needed to sustain an adult, and by converting it
into US dollars. The international poverty line was originally set at $1
a day and has currently been updated to $1.25 a day.

Econ 313 Section 1 Sample Midterm

Part IV
This part is worth 15% of your examination
The Lewis model illustrates the manner in which the structure of a traditional agricultural
economy can be altered to induce growth. Explain with a diagram.

Straight from the slides. Diagram is mandatory. (6 + 9

explanation)

= Diagram +