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Econ 116- Econtutor notes

Econ 116- Econtutor notes - 116 Midterm 1 Review A 1...

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1/27/08 116 Midterm 1 Review A 1. Measurements of Economic Development a. Standard one – per capita income $GDP/person b. Problems with Per capita Income i. Purchase Power Parity (PPP) Law of One Price assumes that similar goods cost the same in different countries once you adjust for the exchange rate. ii. But a dollar buys more in a poor country then a developed country. iii. More concretely services tend to be cheaper. iv. Problem w/the Law of One Price c. PPP$ adjust the per capita income for the PPP problem. i. Without the PPP adjustment you get weird things like $40,000 in US (per capita income) and would only be $400 in Nepal. ii. With the PPP adjustment you get it closer like 40,000 US and 4,000 Nepal. Which seems more reasonable. d. Human Development Index (HDI) this tries to capture more than just income, it also tries to capture the quality of life. i. It is an average of indexes on (1) Life Expectancy (2) Education Attainment (3) Income (GDP per capita). e. HDI = (1/3) [Life Expectancy Index] + (1/3) [Educational Attainment Index] + (1/3) [Income Index] = (1/3) [(Value – 25)/(85 - 25)] + (1/3) [(1/3)[(Enroll – 0)/(100 - 0)] + (2/3)[(Adult Lit – 0)/(100 – 0)] + (1/3) [(ln[GDP per capita] – ln (100))/(ln(40,000) – ln(100)] f. If Kenya Life Expectancy = 60, Enrollment = 40%, Adult Lit. = 80%, GDP per Capita ($PPP) = 10,000 (1/3)[(60 - 25)/(85 - 25)] + (1/3)[(1/3) [(40 – 0)/(100 – 0) + (2/3)[(80 - 0)/(100 – 0)] + (1/3)[(ln(10,000) – ln(100))/(ln(40,000) – ln(100))] = .67 HDI (Kenya) on a scale from 1 to 0 where 1 is the highest. Question 1: HDI/Law of 1 Price a. To construct on component of the HDI, the log of per capita income is used instead of the level of per capita income. For e, if per capita income is $3,000, log (3000) is used instead of 3000. What is the reason fro using the log instead of the level? a. We want to incorporate diminishing returns to wealth, i.e. an extra dollar is worth a lot more to a poor person than a wealthy person. You don’t want to have a linear measure to wealth, because that implies a linear measure to utility. The log transformation is concave, so it provides diminishing marginal utility (diminishing returns). You could also use the square root of wealth b. We have noted that, on average, services are cheaper in poor than in rich countries. Commodities, however, are similar in price on average in poor as in rich countries. Why? a. Commodities are tradable goods. If similar gods don’t cost the same, you can make a profit from buying low and selling high. Services
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(like haircuts) are not tradable. The price of services is heavily influenced by the labor market i.e. most service are labor intensive. Services are cheaper in LDC’s because labor is cheaper. b. Why is labor cheaper? i. Factor Endowment Many LDC’s have large populations, so there is a surplus of labor, which lowers the wage rate. ii. Productivity Argument Most LDC’s don’t have a skilled labor force. In the industrial sector, wages reflect productivity, so industrial wages are low and service sector wages are related to the industrial wages. They are low as well. The service and industrial wage results are linked, so the low industrial wage results in a low service sector wage.
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Econ 116- Econtutor notes - 116 Midterm 1 Review A 1...

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