Joanna Orlova

U14781559
11.05.2015
Professor Ajayi
Team Costa Rica
EC320: Economics of Less Developed Regions Homework 3
1. Structural Transformation Theory
Consider the economy of Lewisville, which is just beginning to industrialize. The economy was
entirely reliant on corn production until now. There are 100 identical families each farming their
own land. Each family has 6 members who participate equally in farm work and share the output.
Each farm has a small land area and can employ up to 3 full time workers, each of whom produce 1
unit of corn. Beyond 3 workers, additional workers generate no additional farm output. Hence
farm output c=min{3,x} where x is the number of workers on the farm.
In response to an industrialization policy adopted by the government, new factories have recently
started opening up in Lewisville. Each new factory produces shirts using labor, and the marginal
product of labor in each factory is 10-y, where y is the number of workers. Workers are free to
move between farm and factory with no migration or transport costs.
Factories are owned by entrepreneurs who maximize profits. They save 10% of their profits and
invest these profits to build new factories, which start the following year. Each new factory requires
a set up cost equal to 32 shirts.
Lewisville trades with the rest of the world and is too small to affect world prices. Hence, shirt and
corn prices are fixed: the price of corn relative to shirts is 4, and each shirt can thus be sold at a
price of 0.25 units of corn.
(a) Before the factories, what is the average product of labor (corn output/worker) in each
farm? What is the marginal product of labor? What proportion of the economys labor
force is surplus?
The average product of labor is given by the following function, given that labor input is x:

x
=1( x m)
q min ( x , m) x
=
=
x
x
m
( x>m)
x
Due to each family having n siblings, 6 siblings, who participate equally in the farm work, and
n>m, 6>3, average product of labor in year 0 is

m
n , which is 3/6= .5

When x<m, one more worker will produce one more unit of corn. When x m , one more
worker will produce no additional corn. Therefore, the marginal product of labor is:

1(x <m)
0(x m) Therefore, in year 0 marginal product of labor is 0 because n>m, 6>3

In the case where x m , any additional labor input will have no effect on output and as a
result the surplus labor ratio in year 0 is

nm
, which is .5
n

(b) In year 1, 20 new factories arrive. With wages in agriculture set to the average product of labor
and free mobility between sectors, what will the wage rate in the industrial sector be in units of
shirts? How many workers will each factory employ in year 1? [Hint: WI = APLA * PA (where PA
is price of corn relative to shirts).]
Each factory will employ the amount of workers where marginal cost equals to marginal revenue.
Marginal revenue of a factory is measured in shirts, it equals the marginal product 10-y, while the
marginal cost of labor is APLa * Pa
10-y= APLa * Pa
10-y=.5*4, 10-y=2, Y=8
(c) What is total employment in industry in year 1?
To obtain employment per factory, multiply the number of workers per factor by the number of factories
to obtain total factory employment: F1*y= 20*8=160 total employees
(d) Will there be surplus labor in agriculture in year 1?
There are a total of 600 people, with 300 working in agriculture, 160 working in industrial, and so a total
of 140 are extra, which means a surplus of 140 people, with 600-160=440 is now the agricultural
workforce, with 140/440= 31.8% are surplus
(e) How many factories will there be in year 2 given that each factory earns of a profit of 32
(=1/2*y(10 - WI)) in year 1?
Total saving of factories is:

New factories being built is:

Number of factories in year 2 is a fixed ratio of F1, so:

G is denoted by

which we can simplify to the expression: F2 = (1 + g)F1

Given that F1 is 20, and g=10%, F2=1.1*20=22 factories in year 2

(f) Will there be surplus labor in agriculture in year 2?
Yes, there is still a surplus of labor of 22*8=176+300-476, 600 total-476= 124 extra workers

(g) Suppose the government introduces a tax credit that increases the savings rate to 0.45. How
many more years will it take for all surplus labor to transition out of agriculture?
After 2 more years, in year 4, because this is when there will no longer be any surplus labor
22 year 2 factories
workers per
8 factory

=22*1.
31.9 45

1.4 post year 2

5 savings rate

=300-255.2, surplus in
44.8 year 3

255.2

46.255 =31.9*1.45
=46.25
370.04 *8
300370.04

No longer in surplus
-70.04 year 4

2. Structural Transformation Trends

Using the WDI, download the full historical time series on the urban population share and the share
of employment in agriculture in your country. Using excel or Stata, plot the two variables on the
same graph with the year on the x-axis. Also calculate the correlation between the two. Briefly
describe the trends and patterns.
2.

Structural Transformation Trends

Year

Urban population (% of total)

Employment in agriculture (% of total employment)

1980 [YR1980]

43.099

27.40

1981 [YR1981]

43.45

27.60

1982 [YR1982]

43.803

30.00

1983 [YR1983]

44.156

28.20

1984 [YR1984]

44.542

30.70

1985 [YR1985]

45.445

27.30

1986 [YR1986]

46.353

26.90

1987 [YR1987]

47.263

28.10

1988 [YR1988]

48.176

28.10

1989 [YR1989]

49.088

26.20

1990 [YR1990]

50.002

25.90

1991 [YR1991]

50.916

25.50

1992 [YR1992]

51.83

24.10

1993 [YR1993]

52.741

22.60

1994 [YR1994]

53.651

21.40

1995 [YR1995]

54.559

21.60

1996 [YR1996]

55.465

21.60

1997 [YR1997]

56.365

20.60

1998 [YR1998]

57.262

20.10

1999 [YR1999]

58.154

19.70

2000 [YR2000]

59.049

20.40

2001 [YR2001]

60.407

15.60

2002 [YR2002]

61.751

15.90

2003 [YR2003]

63.077

15.10

2004 [YR2004]

64.385

14.80

2005 [YR2005]

65.669

15.20

2006 [YR2006]

66.932

14.00

2007 [YR2007]

68.172

13.20

2008 [YR2008]

69.387

12.30

2009 [YR2009]

70.573

12.30

2010 [YR2010]

71.734

15.00

2011 [YR2011]

72.866

14.10

2012 [YR2012]

73.94

13.40

Correlation is -.9669

The data that was available for both of the variables, urban population as a percent of total and
employment in agriculture as a percent of total employment, is shown above. There is an obvious
negative correlation between the two variables, with a correlation coefficient of -.9669. The urban
population share has been steadily growing while the share of employment in agriculture has been
steadily decreasing. The correlation coefficient was -.9669 which indicates a strong negative correlation
between the two. This result is expected because as more people move into cities, naturally that means
that less people will be working in the rural farming sectors like agriculture.

3. Sharecropping, Fixed Rents, and Risk Aversion

Consider the decision-making of farmers in a poor rain-fed agricultural area of India. Suppose that
there are two possible outcomes at the end of each growing season depending on the amount of
rainfall: the good outcome generates revenue of $100, the bad outcome generates $50. Due to
historical reasons associated with the British colonizers treatment of wealthy landowners, fixed
rent contracts are $30 in region A and $20 in region B. Suppose that all land sizes are identical and
the only input to production is labor, and the cost of labor (inclusive of opportunity costs) is fixed at
$30.
(a) Suppose that there is a 70% chance of good rainfall. What is the expected income under fixed
rent contracts for a tenant in region A? in region B? What about expected profits?
a. The expected revenue for tenant A would be ($100*.7)+($50*.3)= $85. $30 would then be subtracted
for the rent contract and it would be $85-$30=$55. Then after labor costs of $30, tenant A is left with a
profit of $25. For a tenant in region B, the expected revenue would be the same but then we would
subtract only $20 for rent leaving tenant B with $65, and then we would subtract the $30 for labor
resulting in a profit of $35.

(b) Now suppose that there has been a dramatic increase in factory jobs in nearby towns leading to
an increase in the (opportunity) cost of labor on the farm to $60. Will tenants in region A still accept
the fixed rent contracts? in region B? What is the maximum fixed rent rate that tenants will accept
in each region?
b. If the cost of labor is increased to $60, then the tenants in region A will not accept the fixed rent
contracts because they would have a net loss of -$5. The tenants in region B on the other hand would still
be making a profit of $5 so it is possible that they would still accept the fixed rent contracts. For both
regions, the maximum rent they would accept would be $25, if the cost of labor is $60.
(c) Going back to the original assumptions, what sharecropping rule (i.e., what value of ) will
make landlords indifferent between fixed rent and sharecropping contracts? Use the resulting * to
show that tenants will prefer fixed rent instead of sharecropping in the case of good rainfall but
sharecropping in the case of bad rainfall.
c. With the original assumption of 70% chance of good rainfall, the expected outcome revenue for
tenant A is $85. The alpha would be calculated by 30/85=.3529, which means that the landlord would be
indiffered between fixed rent at $30 and a sharecropping contract with this alpha. Similarly in region B, a
landlord would be indifferent about the fixed rent at $30 with an alpha of 20/85 = .2359. Combining the
two, we get an overall alpha* = .2941. As a tenant in region A, with an alpha level of .3529, in a good
rainfall year A would have to pay $35.29, so the fixed rent of $30 is more favorable. In bad rainfall,
however, A would only have to pay $35.29/2= $17.65, and this is better than the fixed rent of $30, so
sharecropping is more favorable. For region B, in good rainfall it would also prefer the fixed rent of $20
because its less than the sharecropping cost of $23.59. In a bad rainfall it will prefer sharecropping
because it would only have to pay $23.59/2=$11.80 which is less than the $20.
However, if there was just one landlord and a sharecropping system with one overarching alpha = .2941,
then region A would prefer sharecropping in both good and bad rainfall because theyd only have to pay
$29.41 with good rainfall, and $14.71 with bad rainfall. Region B on the other hand, would prefer fixed
rent of $20 when there is good rainfall, and would prefer to do sharecropping and pay the $14.71 when
there is bad rainfall.
(d) Going back to the original assumptions, now suppose that irrigation canals are widely available
and reduce farmers dependence on rainfall. Conceptually, this lowers the chance of a bad outcome
by 10%. How would your answers to (a) and (b) change? Discuss the intuition for this result.
If the chance of a bad outcome is lowered by 10%, the chance of a good outcome has risen by 10% which
brings the chance of good rainfall up to 80%. This means that the expected revenue changes to
($100*.8)+(50*.2) = $90. For region A, you would subtract the $30 for rent which brings it to $60, and
then subtract $30 more for labor. This would create a profit of $30 for region A.
For region B, the expected revenue would be $90, minus the $20 for rent. This would yield to $70 and
then $30 for labor would be subtracted, and would leave expected profits of $40. In this case now, the
answer to question b would change because the people in region A would theoretically accept the fixed
rent contract because their profit would net 0 and the people in region B would have a profit of $10. In
this case the maximum fixed rent would be $30. This is a result that we would expect because a higher
chance of good rainfall intuitively implies a higher expected revenue and thus would make the farmers
more likely to accept higher rent or labor costs.

(e) Going back to the original assumptions, suppose that landlords adopt a small dose of altruism
and decide to offer limited liability contracts in which they will return 50% of the rental payment at
the end of a bad rainfall season. What is the new expected income under fixed rent contracts for a
tenant in region A? in region B? What are the implications for contract choices?
In region A, with the chance for bad rainfall is 30%, the new expected income would be the $85 from
above, plus 30% of $15(which is 50% of $30) or $4.50, yielding $89.50 as the expected revenue for a
tenant in region A. After subtracting the $30 for rent were left with $59.50. Subtracting $30 for labor and
the tenant would have $29.50 in profit.
In region B, The new expected income would be the $85 from above, plus 30% of $10 (which is 50% of
$20) or $3, yielding $88 as the expected revenue for a tenant in region B. After subtracting the $20 for
rent, wed be left with $68. After subtracting for labor of $30 wed be left with $38 profit. The
implications are that if the rent losses are reduced in bad rainfall, the landlord can potentially charge
greater overall rent costs.