Question Economics 541, Mid-Term Examination Winter 2014

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.

1. 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)

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