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Exam II
NAME ________MIM_______________________
Part I – Short Essay: (15%)
2)
Describe the Inverted U-hypothesis and list some of the reasons behind it.
The Inverted U-hypothesis refers to the relationship between the degree of income
inequality in the economy and the state of economic development. Typically, the curve is
plotted in the GDP per capita and the inequality measure space.
The observation, first discovered by Kuznetz in the 50’s, refers to the nature of
the relationship. At low levels of economic development, a higher GDP per capita is
likely to be correlated with a higher degree of income inequality, but as the level of
economic development rises, the sign of the correlation changes. Countries with higher
GPD per capita begin to exhibit lower levels of inequality. Empirical support to that can
be seen in the data presented in class in the ID.XLS file: Countries like Sweden, Norway,
Finland, Germany, the USA all have lower degrees of inequality when compared to
countries like Argentina, Brazil, Uruguay, Uganda.
Several reasons can serve as possible explanations to this phenomenon:
I.
Introductions of new technologies into the developing economies. As new
production technologies are introduced into the economy, at first the
benefit is concentrated to a very select group of people. For example,
when foreign firms come to China, the benefit initially is focused on those
few workers who get the jobs offered by foreign firms. With time,
domestic firms will start to develop and adapt the newly introduced
production technology, causing a spillover of the benefits to the wider
population.
II.
The “tunnel” effect. This is somewhat similar to point I, just think of this
in terms of people instead of firms. People tend to adjust, and when they
see that other members of the society are moving forward, they start to
mimic the mechanisms that are responsible for that movement. For
instance, if my neighbors buy better cars and enjoy a better standard of
living, the choice of their occupation may be responsible (just think of
computer programmers in the 90’s). In which case, I may select to get the
skills necessary for that occupation and adjust.
III.
Education. With higher degree of economic development comes a more
available to the general population educational system. Education can be
viewed as a major equalizer, and in developed countries differences in
education levels tend to be lower than in developing countries.
IV.
More developed countries may select to redistribute wealth more. For
example, this may be a more easier policy to implement due to
diminishing marginal utility of money principle (this is a somewhat weak
point). Progressive income taxation is a characteristic of this.
Part II – True/False (EXPLAIN!!! The explanation is the most important part of the
answer) (50% - 10% each)
1)
The Russian economy today, along with most other Eastern European
economies, employs a flat “proportional” income tax rate system with a
deduction for the minimum cost of living (minim wage income). Such tax
system is NOT progressive.
False. Although it sounds that a flat rate income tax system is proportional rather than
progressive, the deduction (or the zero rate bracket) makes it a progressive system. A
progressive tax system is one where the average tax rate is rising with the income level of
the taxpayer. The zero rate bracket in the flat Eastern European tax systems ensures
progressivity.
2)
Foreign Direct Investment can serve as a vehicle for transferring technology
from a wealthier “developed” economy to a poorer “developing” economy.
True. Foreign Direct Investment represents a concentrated ownership by a foreign entity.
FDI often represents either a set up of business by a foreign entity or a joint venture with
a domestic firm. This doesn’t just bring foreign capital to the country and hence creates
jobs, but it can also bring foreign production technology, management system and etc. In
essence, FDI can serve as an excellent tool for transferring production technology.
3)
Paradoxically, investment into education without matching job creation may
lead to reduction in the level of human capital in the country, especially if
international labor mobility is unrestricted, or weakly restricted
True, the key to this question is in the phenomenon of brain drain. If a country spends
considerable resources on education, but fails to provide employment opportunities, then
its educated population may seek employment overseas. This phenomenon is very
common in most African economies, in India and Pakistan, in Russia and other Eastern
European states. This may very well leave the domestic economy with a lower level of
human capital. It is also alarming that it is the most intelligent workers who seek
education, and their emigration reduces the quality of the labor force.
4)
In the absence of a developed financial sector, concentrated wealth
distribution may act as a substitute to the financial sector and enable
establishment of large size family owned businesses.
True. The financial sector pulls the savings of many individuals to create a pool of
available for lending funds. In the absence of such sector, raising substantial capital
becomes difficult. If the wealth distribution is concentrated, then it acts as a substitute to
the pool of loanable funds created by the financial sector. This is a characteristic of many
if not most developing countries, and as a result you often find large size businesses in
developing economies being largely owned by a very small number of individuals,
sometimes families.
5)
If the production function in the Solow Growth model includes only two
inputs: physical capital and human capital, but still remains a CRTS function,
then the economy can experience a long run positive economic growth
(provided no depreciation applies to human capital).
True. In this formulation the overall output is increasing when we accumulate human and
or physical capital. Thus, on per capita basis positive long-term growth is possible. To
easily see this, assume that population is not growing, and yet investment into human
capital is positive, then the level of output overall is increasing, making the output per
worker grow.
Part III – the Gini coefficient (35%)
1)
Consider the following distribution of income schedule:
% share
of
population
20
20
20
20
20
I
II
III
IV
V
a)
% share
of
income
2
12
15
30
41
(10%) What is the Gini Coefficient for this economy?
Population is normalized to 5, average income to 20.
Differences:
From I  10+13+28+39= 90
From II  10+3+18+29= 60
From III  13+3+15+26= 57
From IV  28+18+15+11=72
From V  39+29+26+11= 105
Sum of all differences: 90+60+57+72+105= 384
The Gini = (1/[2*25*20]) * 384 = 384/1000 = 0.384
b)
(10%) Please plot this economy’s Lorenz curve in a clearly labeled space
100%
59
%
29
%
14
%
2%
20
%
40
%
60
%
80
%
100%
2)
I
II
III
IV
(10%) Now, consider the following income distribution scheme:\
% share
of
population
25
25
25
25
% share
of
income
5
15
25
55
What is the Gini Coefficient now?
Average income is normalized to 25, population to 4. Differences:
From I  10+20+50=80
From II 10+10+40=60
From III  20+10+30=60
From IV 50+40+30=120
The Sum of differences: 80+60+60+120 = 320
The GINI = [1/(2*16*25)]*320 = 320/800 = 0.4
3)
(5%) In which of the two preceding problems the income distribution exhibits
greater inequality?
Based on the Gini numbers the distribution in problem 2 has the greatest degree of
inequality.