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Economics 541 - Mid-Term Examination Winter 2014




Question;Economics 541;Mid-Term Examination;Winter 2014;There are a total of100;marksavailable.;Question 1. (30 marks;total);In the unbundling;institutions paper we saw that the value of undertaking production to producerjwas;Uj(ej) =F(P)a????1????mi????ej,whereejis the;idiosyncratic individual cost of undertaking the project,miwas the;cost of writing the financing contract (i=dfor debt;contract ori=efor equity contract),awas the return on the project and;F(P) was the probability that a project was not expropriated by the state.;There are a few noteworthy things about this equation. Firstly, the costs of;going to court,Cido not enter into this;expression.;A. Is it safe to conclude;that it is always beneficial to have a legal system with a cheaper cost of;writing contracts (i.e., lowm) even at the costs of higherC:? Explain;why or why not with reference toRthe;interest repayments required on loans anda. (10 marks);B Is it safe to conclude;that it is always beneficial to have a political system where the probability;of being expropriated (1????F(P)) is;always low? Discuss with reference to both the feasibility offinancial markets;existing (the condition relatingRanda) and;with regards to the level of investment that will be undertaken given the feasibility;of lending. (5 marks);C. Suppose that lending;were not competitive, so that lenders would be able to extract some rents from;theirfinancing operations. Would this afiect the feasibility condition for the;lending market (i.e., thecondition;relatingRand;a).;Explain whether it afiects it either qualitatively, quantitatively or both. (10;marks);D. The main conclusion;from the empirical part of this paper was that;the quality of political;institutions seemed to have a large efiect on economic outcomes (GDP per;capita) whereas the quality of legal institutions determined only the form thatfinancial;contracts take (amongst other things perhaps), but did not afiect the overall;level of investment or economic outcomes. How does;this finding link to the;theoretical part of the paper? Discuss with relation to the choice of debt;versus equity financing. (5 marks);Question 2 (20 marks;total);The main insight of the;Greif model, considered in class, has to do with moral hazard in trading;situations. He considers a canonical principal agent problem in which the;principal (a merchant) has no extraneous means of enforcing contract and;punishing agents who cheat him, and must rely on the threat of terminating the;relationship with the agent to provide incentives for the agent to trade honestly.;The insight is that close knit groups of traders who share information, or at;least condition their actions on what happens to their colleagues and not just;on what happens to themselves can actually sustain a broader set of trading outcomes;than do traders who act in isolation.;Explain;intuitively why this is true in his set up. (5 marks);B. In his paper, the;Genoese are the individualists, but the Maghribi are the collectivist. The;historical record suggests that it is the Genoese who came to dominate trade in;the Mediterranean, whereas Maghribi inuenced was limited and eventually waned.;Explain how he argues that this is consistent with the principal agent set up;he considers. (5 marks);C. Now suppose thatfi= 0 that;is, trading relationships are never dissolved for exogenous reasons. Recall;also that nobody ever dies either. Explain intuitively why the relationship;between wages here is now difierent than whenfi >0, i.e.;in the standard model. (10 marks);path, if an agent were;to cheat, then a single job would become;Question 3 (15 marks;total);Karlan and Zinman (2009);designed afield experiment to seperately explore the inuence of Moral Hazard;and Adverse Selection in the credit market. They sent letters ofiering clients;of a South Africanfinancial institution an opportunity to borrow. The rate at;which they were invited to borrow was randomized;so that difierent groups;ended with difierent ofier rates. Suppose half received ratexand the;others ratex=2. Now, among those who agreed to borrow at an 3 initially high rate,x, they;randomly selected half of the clients and surprised them with the lower rate of;interestx=2.;A. Tell me { and explain;your reasoning { which two groups should be compared to isolate the pure efiect;of adverse selection on repayment rates. (5 marks);B. Tell me { and explain;your reasoning { which two groups should be compared to isolate the efiect of;moral hazard on repayment rates. Explain why this is not, however, the pure efiect;of moral hazard, why there is also the possibility that something else could be;afiecting behavior. (10 marks);Question 4 (15 marks;total);Consider the \Theory of;Political Transitions" paper by Acemoglu and Robinson (2001). Commitment;problems and threats on both sides of the class divide are the key to why democratization;can occur there. The poor would like higher taxes and more redistribution, and;they are able to threaten revolutions that will (severely) destroy future value;of the Rich. The Rich, on the other hand, would like lower taxes and less;redistribution and they can threaten coups that will take power from the poor;and also destroy value. The threat of revolutions enables the rich (if they are;in power) to commit to redistribution to the poor (in the future too). The;threat of coups allows the poor (if they are in power) to commit to not too;high a level of expropriation of the rich (in the future too).;A. Explain intuitively why;the state of the economy impinges on these commitments. In particular, what the;efiect of the economy being in a low state of productivity has on the;willingness of the group in power to accomodate the group out of power. (5;marks);B. Explain intuitively why;an increase in the frequency of recessionary periods makes democratizationlesslikely.;(5 marks);C. Explain intuitively why;more economically equal societies are less likely to democratize. (5 marks);Question 5 (20 marks;total);In the Nunn (2006) paper;on the efiects of slavery in Africa a key step was the use of instruments to;isolate a potentially causal efiect of slavery on present day outcomes. He used;distances from each African country to the locations where the slave labor was;eventually used as instruments.;Consider the following;factors { treaing each one seperately { and explain, briey, whether the factor;invalidates the use of these instruments;A. Suppose that sugar;plantations were established in the West Indies because West Indies were close;to the Western Coast of Africa. 5 marks;B. Suppose that the;plantation economies in theWest Indies were established there because of the;high price of sugar and that there was massive demand for labor that;pre-existed the development of slavery in Africa. 5 marks;C. Suppose that distance;to the coastal ports is correlated with high rates of endemic disease like;Malaria { prevalent at the time of slavery and today. 5 marks;D. Suppose that the;countries in which many people were enslaved were also countries where there is;a high rate of HIV infection. 5 marks


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