Economics 448 Prof Walker

Autumn 2013 Page 1

Economics 448: Problem Assignment #1

In Development Economics:
1. Chapter 2 question 6. Use Table 2.1 to construct what is known as a Kuznets ratio (named
after economist and historian Simon Kuznets): the ratio of incomes earned by the richest
20% of the population to those earned by the poorest 40% of the population. If incomes were
distributed almost equally, what value would you expect this ratio to assume? What value
do you see? In the sample represented by Table 2.1, do you see a trend as we move from
poor to rich countries?
Answer: Ray 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 inequality. 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.
2. Chapter 2 question 9.
(a) Why do you think population growth rates fall with development? If people consume
more goods, in general, as they get richer and children are just another consumption
good (a source of pleasure to their parents), then why don’t people in richer countries
“consume” more children?
Answer: JRW With development incomes increase, but labor market opportunities also
increase, especially for women. Assuming that children are another consumption good
the increase in household income will increase the demand for children (assuming that
children are “normal goods”, i.e., those with positive income elasticities of demand).
Yet, child bearing and child raising are time intensive activities. The increase in oppor-
tunities for women increases the value of her time. Consequently, the (shadow) price
of children increase with development. The decline in the number of children in devel-
oping countries implies that the substitution effect of more costly children dominates
the income effect.
(b) Why are countries with higher population growth rates likely to have a greater propor-
tion of individuals below the age of 15?
Answer: JRW This has to do with population momentum. The number of births in a
year (bt equals average birth rate, [ABR, of women ages 15–45] times the the number of
f f
women in child–bearing age Pt , bt = ABRt × Pt A change in behavior, say away from
childbearing will reduce the ABRt immediately, but the number of women of childbear-
ing age will change only gradually. All women born when fertility rates were high have

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to pass through their reproductive ages before the number of births per year decline.
(c) Are poorer countries more likely to be rural or is it that rural countries are more likely
to be poor? Which way does the causality run, or does it run in both ways?
Answer: JRW The causality runs both ways. Rural countries are more likely to be poor
as it is likely they have little to no industrial sector. So, labor works relatively little
capital and therefore has low productivity and low earnings. A country that is poor
probably offers few incentives for workers to leave the agricultural sector and move
into the higher paying industrial sector. As we have seen from Global Economic History
urbanization is concomittant with industrialization. Hence, causality likely runs both
directions.
(d) Why do you think the international price of sugar might fluctuate more than, say, that
of automobiles?
Answer: JRW Inventories of agricultural commodities are expensive to store relative
to the value of the commodity. Thus, inventories are kept low and are seasonal (high
immediately after harvest and low just prior to harvest). For automobiles storage costs
are cheap relative to the value of the product. Thus inventories are large and need not
follow a seasonal pattern. Thus, as the price of sugar increases with low inventories
there is little surplus to be released to the market. With automobiles however as the
relative of price of automobiles increases sellers will sell of their inventories increasing
supply and dampening the market increase in price.
3. Chapter 16, question 1.
(a) Why might an increase in trade volume not correspond to an increase in hard–currency
earnings? Illustrate your argument by using the example of a devaluation, which is a
deliberate cheapening of the exchange rate—the rate at which domestic currency can be
exchanged for foreign curreny, say dollars.
Answer: Ray 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, ex-
ports 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 interna-
tional price, but in general it will remain higher in domestic terms.
(b) Why does a devaluation tend to increase the exports of a country, expressed in the local
currency or in physical units?
Answer: Ray As the last part of the previous answer suggests, the effect of a devalua-
tion 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 coun-
tries that manufacture a 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 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.

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(c) Discuss when the devaluation can raise export earnings denominated in the foreign cur-
rency. You can profitably use the concept of price elasticity of demand in your discus-
sion.
Answer: Ray 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 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.
4. Consider the Ricardian model of trade described in this chapter. Use Table 16.5 to answer
the questions that follow.

Table 16.5
Labor Required One Computer One Sack of rice
In N 10 15
In S 40 20

(a) Show that if the relative price of computers to rice were any amount smaller than 2:3
country N would only produce rice. Likewise, show that country N will only produce
computers if the relative price of computers to rice were to exceed 2:3.
Answer: Ray 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 2 10
< =
pr 3 15
pc pr
<
10 15
That is, revenue in the computer industry would be less than 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.
(b) What accounts for this “knife–edge” behavior1 ? Contrast it with the Heckscher–Ohlin
model, where the production of both goods is consistent with a whole range of relative
prices [see problem (4)].
Answer: Ray This “knife-edge” behavior follows from the fact that the production pos-
sibility frontier is a straight line in this case. In the Heckscher-Ohlin model, the produc-
tion possibility frontier is bowed out, which allows a whole range of price ratios to be
consistent with the production of both goods.
(c) Now carefully redo part (a) for country S, showing that the autarky price of comput-
ers to rice must be 2:1. Combining these two exercises, argue that if both goods are
consumed once, the economics are open to trade and the international relative price of
computers to rice must lie between 2:3 and 2:1.
Answer: Ray The argument in part (a) shows that the “knife-edge” ratio is the ratio of
labor require- ment in the computer industry, to the requirement in the rice industry. In
the case of country S, this ratio is 40/20 = 2/1.
1 Knife–edge means that small changes can produce large changes in outcomes. Thus in the Ricardian model a small
change in relative prices can shift a country from producing only computers to only rice.

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5. Understand why the Hecksher–Ohlin model does not lead to complete specialization, in
contrast to the Ricardian framework. Take the car–textiles example studied in this chapter.
Recall that in our example, each of these goods is produced by capital and labor, but cars use
capital more intensively. Now an increase the relative price of cars will cause more resources
to go into car production.
(a) Show that this flow of resources will cause the ratio of capital to wage income to rise.
Answer: Ray 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.
(b) Which industry will be more adversely affected by the change in part (a)?
Answer: Ray 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 case, the car indus-
try will be worse off.
(c) Now combine the observations in parts (a) and (b) to show that textile production will
still be profitable, though the total production of textiles will decline. Supplement your
understanding by drawing production possibility frontiers, relative price lines, and the
corresponding production points.
Answer: Ray The initial change that makes car production more profitable than textile
production (the increase in relative price) endogenously changes factor prices so that
textile production will remain profitable.