Answers to

Mid-Term Exam-2010

Global Markets and Institutions

Professor John Coleman

Fuqua School of Business, Duke University

Name: ___________________________________

INSTRUCTIONS:

1. By signing this exam, you state that you have followed the Fuqua honor code in solving this exam.

2. You have one and a half hours to complete this exam. This is a

closed-book, closed-notes exam.

3. All the articles, graphs, tables, etc., are at the end of this exam.

4. In answering the questions, be specific in using the material from this course. You will be graded depending on how well you integrate the material from this course into your answers.

Total Points: 100

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1. (40 points) Please read the paragraph under “1. Article” and answer the following questions. (a) (10 points) Explain the concept of Total Factor Productivity (TFP). What

does this have to do with long-term growth? TFP measures overall productivity of capital and labor for producing GDP. It does not depend on the amount of capital and labor that is used for producing goods. A doubling of TFP, e.g., means that twice as much GDP can be produced with the same inputs of capital and labor. Long-term growth in per-capita GDP can only be sustained by long-term improvements in TFP. Due to diminishing returns to capital, a rise in capital per worker will not sustain long-term growth. (b) (10 points) What does “technological diffusion” (i.e., the spread of

technology from one country to another) have to do with TFP and differences in per-capita income?

A significant source of disparity in per-capita income across counties is a disparity in TFP, and a significant source of disparity in TFP is the different technologies that are used. Transmitting technology from an advanced economy to a developing one is necessary to achieve convergence in levels of TFP, which is the only way to achieve convergence in per-capital levels of GDP. (c) (20 points) Why should “institutions” lead to persistent differences in

TFP and income across countries? List at least four features of institutions that are important for growth, and why, that we discussed in class.

High quality institutions create the environment for engaging in activities that promote higher levels of TFP. Examples of important institutions are: (1) legal system (for the enforcement or property rights, efficient bankruptcy laws, etc), (2) functioning markets (to specialize and leverage your skills), (3) health and education systems (a skilled work force is necessary for adopting and efficiently using the best technology), (4) financial institutions (which are important for efficiently allocating resources), and (5) government bureaucracy (for adopting good policies).

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2. (30 points) Take a look at the two graphs in “2. Figures” and answer the following questions. (a) (10 points) The graphs of labor productivity in China show that labor

productivity is lower in agriculture than non-agriculture but that labor productivity is growing faster in agriculture than in non-agriculture. According to what you learned in class, how should these trends relate to wage rates in these two sectors? Why?

The wage rate should equal the marginal productivity of labor. Hence, in China the wage rate should be lower in agriculture than in non-agriculture, but the wage rate should be rising faster in agriculture than in non-agriculture.

(b) (10 points) The graphs also show a declining agricultural sector in

China. Given your answer in (a) above, what explains the decline of the agricultural sector? What else (perhaps education and/or migration) must be going on in China and how is related to the trends just described?

Since the wage is higher in non-agriculture, people who are able to will migrate from agriculture to non-agriculture. Wages are higher in non-agriculture because of the higher level of skills required for the non-agriculture sector. Hence, what must be going on in China is an accumulating of skills that allow the workforce to transition out of the low-wage agriculture sector to the high-wage non-agriculture sector. (c) (10 points) Describe the general pattern that we observe around the world regarding the relation between per-capita GDP and the shares of employment in agriculture, manufacturing, and the service sector. Provide one explanation regarding these trends.

Poor countries tend to be heavy in agriculture. As they growth they transition into manufacturing and services and out of agriculture, but at some point countries that continue to growth also transition out of manufacturing and become predominantly service-oriented economies. Poor countries are in agriculture because their workers are largely unskilled, and agriculture requires mostly unskilled labor. As countries acquire skills they transition out of agriculture. They eventually transition out of manufacturing as the lack of productivity growth in services creates a bottleneck and a rise in the price of services, and hence draws employment into the service sector.

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4. (30 points) Take a look at the table in “3. Table” and answer the following questions. (a) (15 points) State clearly the theory of comparative advantage. Note that the data in the table exhibits a significant amount of intra-industry trade. Define intra-industry trade. Why is it difficult to explain intra-industry trade from the classical perspective of comparative advantage? Comparative advantage explains that trade is motivated by a relative productivity advantage: a country has a comparative advantage in producing Good A if its productivity or producing Good A relative to Good B is higher than that ratio for other countries. Intra-industry trade is defined as trade between countries within an industry, such as automobiles, textiles, office machines, etc. Since one would expect productivity in various goods within an industry to be approximately the same within a country, Comparative Advantage suggests that trade between two countries will consist of trade in different types of goods or industries (as well as countries that are economically different from one another). Comparative Advantage thus has difficulty explaining trade within an industry (especially amongst similar countries). (b) (15 points) Provide a brief description of New Trade Theory that we discussed in class. Describe how the New Trade Theory that we covered in class explains intra-industry trade. The New Trade Theory hypothesizes the following: (1) an industry is characterized by differentiated products, each of which is produced with increasing returns to scale, and (2) consumers in each country wish to purchase a wide variety of goods. Due to economies of scale, it is most efficient to produce some varieties in only one country and other varieties only in another country. Due to a demand for variety, all varieties will be consumed in each country, thereby leading to intra-industry trade. Note too that the feature of product differentiation will lead to each firm having some monopoly power in pricing its good.

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1. Article

Bloom, Canning, and Sevilla, “Technological Diffusion, Conditional Convergence, and Economic Growth,” NBER Working Paper 8713, 2002. Technological diffusion implies a form of “conditional convergence” as lagging countries catch up with technological leaders. We find strong evidence of technological diffusion but not full convergence; differences in total factor productivity (TFP) persist even in the long run due to differences in geography and institutions. TFP differentials explain a large part of cross-country income differences in our model …

2. Figures

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3. Table

Answers to

Mid-Term Exam-2010

Global Economic Environment of the Firm Name: ___________________________________

INSTRUCTIONS:

1. By signing this exam, you state that you have followed the Fuqua honor code in solving this exam.

2. You have two hours to complete this exam. This is a closed-book,

closed-notes exam.

3. All the articles are at the end of this exam.

4. In answering the questions, be specific in using the material in the course. You will be graded depending on how well you integrate the material from the course into your answers.

Total Points: 100

1. (40 points) Please take a look at Figure 1 and use the concepts in class to answer the following questions. (a) What explains the stagnant growth and equality of income for the history of the world prior to the 1800s? Prior to the Industrial Revolution, the efficiency of production (total factor productivity) did not exhibit sustained growth, and its level in one region of the world was not too different from that in another. Because of diminishing returns to capital, sustained growth in per-capita income was not possible, nor could one region of the world become much richer than another. (b) What explains the sustained per-capita income growth in the US since the 1800s and the widening inequality of income between countries beginning in the 1800s? In your response, refer to the four features of an economy (referenced in the Goldman Sachs article) the seem to be associated with long-term growth. The Industrial Revolution was a revolution in the efficiency of production (total factor productivity) using capital-intensive methods as opposed to land-intensive methods. The US experienced a sustained rise in the efficiency of production following the Industrial Revolution. Many factors contributed to this sustained rise, such as: (1) high quantity and quality of education, (2) high quality institutions, (3) protection of private property rights and more generally the rule of law, and (4) a stable macroeconomic environment. Regarding the widening income inequality, due to the lack of reforms that have fostered an amazing rise in the efficiency of production around the world, some countries seem to be stuck in a pre-industrial state with no significant sustained rise in the efficiency of production.. Many, although certainly not all, of these countries seem to be embroiled in perpetual conflict, poor institutions, and low levels of education. The world thus seems to be increasingly characterized as consisting of some countries that are become increasingly innovative and rich, and other countries that are stagnant and falling further behind. (c) What explains the lack of complete convergence of Japan to the US level of per capita income since the 1980s? In your discussion, include particular

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concepts covered in class regarding the source of economy-wide productivity improvements. Another source of productivity growth, though, is a dynamic economy that is able to quickly reallocate resources from older, less efficient firms to newer, more efficient firms. Many economies around the world, including Japan, seem to be not as efficient in achieving this reallocation of resources as the US. (d) What explains the recent rise of China’s per capita income? What was the fundamental change that led to this result? Here as well, China’s adoption of free-market reforms laid the groundwork for sustained improvements in the efficiency of production. Along with free-market reforms comes the incentive to be more efficient. Soon after the agricultural reforms in China, for example, productivity in the agricultural sector rose very rapidly. 2. (20 points) Please take a look at Figure 2 regarding the US Current Account, and answer the following questions. (a) Define the Current Account in terms of exports, imports, savings, investment, and international borrowing. What is the typical relationship observed between the Current Account, unemployment, and GDP? Why did the US Current Account rise during 2008 recession? The Current Account measures trade in currently produced goods and services. If a good is exported it is logged as a surplus entry on the Current Account. Thus, CA = Exports – Imports (+ NFP, but this is not important to mention). The CA also measures goods that are produce and not used domestically, either for consumption or investment, so CA = S – I. Note that a CA deficit needs to be financed by international borrowing, so the CA also measures international lending and borrowing (which is logged directly on the capital and financial account, KFA). The typical relationship is a rise in the CA during a recession, as the collapse in investment in a recession, along with a desire to smooth consumption which leads to relatively small changes in savings, leads to a rise in S – I. This is what happened during the recession in 2008 in the US. Since unemployment falls during an expansion, typically a current account deficit is associated with low unemployment.

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(b) If theWorld enter a global recession, what would you expect would happen to the World Wide Current Account? What should happen to World Wide real interest rates? The World Wide Current Account is always equal to zero. If the world entered a global recession, both income and consumption would fall, so there should not be much of an effect on global savings (at the same interest rate). On the other hand, global investment would fall, perhaps substantially, as the return to investing would otherwise fall. Consequently, investment will fall in excess of savings. To maintain an equilibrium in which global savings equals global investment, a global recession should lead to a fall in worldwide real interest rates (which encourages investment and discourages savings). 3. (20 points) Please take a look at Article 1 and answer the following questions. (a) The article makes the point that labor productivity measured as output per worker is “an incomplete gauge of efficiency.” Why is this? Labor productivity can change because of changes in the capital labor ratio, which may have nothing to do with the long-term productive capacity of an economy. For instance, a sudden reduction in employment due perhaps to a bleak forecast of future business opportunities would lead to a rise in the capital labor ratio and hence a rise in labor productivity. (b) In comparison to labor productivity, the article states that “a better gauge of an economy’s efficiency is ‘total factor productivity.’” Why is this? TFP means the productivity of both capital and labor taken together. It is an overall measure of how efficiently these inputs are used in producing GDP. Improvement in TFP directly translates into higher GDP. (c) The article makes the point that China’s rapid rise in total factor productivity differentiates it from the early growth experience of the Soviet Union. Why is this an important point? Use arguments that we discussed in class to make your point. Without a sustained rise in TFP, a country cannot sustain growth over long periods of time. Diminishing returns to capital limit the ability to sustain

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growth merely by accumulating more and more capital. The Soviet Union attempted to growth by excessive capital accumulation in the face of stagnant TFP, but due to diminishing returns to capital was unable to do so. China, with its improvement in TFP, is on a more sustainable path to long-term growth. 4. (20 points) Europe exported 2.6 million motor vehicles in 2002, and imported 2.2 million of them. Japan exported 4.7 million vehicles in 2002 and imported 0.3 million. Please answer the following questions that pertain to this data. (a) Define intra-industry trade. Why is it difficult to explain intra-industry trade from the classical perspective of comparative advantage (in your answer, please clearly state the theory of comparative advantage). Intra-industry trade is defined as trade between countries within an industry, such as automobiles, textiles, office machines, etc. Comparative advantage explains that trade is motivated by a relative productivity advantage: a country has a comparative advantage in producing Good A if its productivity or producing Good A relative to Good B is higher than that ratio for some other countries. Since one would expect productivity in various goods within an industry to be approximately the same within a country, Comparative Advantage suggests that trade between two countries will consist of trade in different types of goods or industries (as well as countries that are economically different from one another). Comparative Advantage thus has difficulty explaining trade within an industry (especially amongst similar countries). (b) Describe how the New Trade Theory that we covered in class explains intra-industry trade. The New Trade Theory hypothesizes the following: (1) an industry is characterized by differentiated products, each of which is produced with increasing returns to scale, and (2) consumers in each country wish to purchase a wide variety of goods. Due to economies of scale it is most efficient to produce some varieties in only one country and other varieties only in another country. Due to a demand for variety, all varieties will be consumed in each country, thereby leading to intra-industry trade. Note too that the feature of product differentiation will lead to each firm having some monopoly power in pricing its good.

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Figure 1

USA

Japan

China

Africa

Figure 2

The US Current Account

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Article 1

Economics focus Secret sauce Nov 12th 2009 From The Economist print edition

China’s rapid growth is due not just to heavy investment, but also to the world’s fastest productivity gains

PRODUCTIVITY growth is perhaps the single most important gauge of an economy’s health. Nothing matters more for long-term living standards than improvements in the efficiency with which an economy combines capital and labour. Unfortunately, productivity growth is itself often inefficiently measured. Most analysts focus on labour productivity, which is usually calculated by dividing total output by the number of workers, or the number of hours worked. According to new figures published on November 5th, America’s output per hour worked has increased by 4.3% over the past year, thanks to big job cuts. Even more impressive is China, where labour productivity has risen by 7-8%.

The snag is that labour productivity is an incomplete gauge of efficiency. Firms can boost output per man-hour by investing more and equipping workers with better machinery. But once the extra capital spending is taken into account there may be little or no gain in overall economic efficiency. Part of the jump in America’s labour productivity during the “new economy” era of the late 1990s reflected a rise in investment as a share of GDP. The huge increase in China’s labour productivity in recent years is partly due to heavy investment rather than true efficiency gains.

A better gauge of an economy’s use of resources is “total factor productivity” (TFP), which tries to assess the efficiency with which both capital and labour are used. Once a country’s labour force stops growing and an increasing capital stock causes the return on new investment to decline, TFP becomes the main source of future economic growth. Unfortunately TFP is much harder to measure than labour productivity. It is calculated as the percentage increase in output that is not accounted for by changes in the volume of inputs of capital and labour. So if the capital stock and the workforce both rise by 2% and output rises by 3%, TFP goes up by 1%. Measuring hours worked is fairly easy, but different ways of valuing a country’s capital stock can produce different results.

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The OECD publishes figures for its rich-country members. These show that since 1990, average TFP growth has been remarkably similar in America, Japan, Germany, Britain and France, at around 1% a year. A recent report by Andrew Cates, an economist at UBS, attempts to estimate TFP growth in emerging economies over the past two decades (see chart). He calculates that China has had by far the fastest annual rate of TFP growth, at around 4%. Probably no other country in history has enjoyed such rapid efficiency gains. India and other Asian emerging economies have also enjoyed faster productivity growth than other developing or developed regions. In contrast, productivity in Brazil and Russia has risen more slowly than in rich economies.

These figures undermine a common claim—that China’s rapid growth has been based solely on overinvestment. Sceptics like to compare China with the Soviet Union, where heavy investment also produced rapid rates of growth for many years before it collapsed. But the big difference is that TFP in the Soviet Union actually fell by an annual average of 1% over 30 years to 1988. In contrast China’s productivity has been lifted by a massive expansion of private enterprise, and a shift of labour out of agricultural work and into more productive jobs in industry. China’s average return on physical capital is now well above the global average, according to Goldman Sachs. A decade ago it was less than half the world average.

Why have the Asian economies led the pack? The most important determinants of longer-term productivity growth are the rate of adoption of existing and new technologies, the pace of domestic scientific innovation and changes in the organisation of production. These, in turn, depend on factors such as the openness of an economy to foreign direct investment and trade, education and the flexibility of labour markets.

Using a composite index of technology penetration and innovation (including, for instance, computers and mobile phones per head), Mr Cates finds a strong link between the rate of increase in an economy’s technological progress and its productivity growth. China’s level of technology is still well behind that in America, but it has seen by far the fastest rate of improvement over the past decade. This is not just because China started from such a low base but also because it is more open to foreign investment than many other emerging economies, including Japan and South Korea when they were at similar stages of development. China’s TFP growth is almost twice as fast as that of Japan and South Korea during their periods of peak economic growth.

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An emerging advantage

UBS’s analysis suggests that the financial health of firms and governments also matters for productivity growth. Although TFP measures the extra gain in economic efficiency after taking account of the direct impact of a larger capital stock, weak balance-sheets constrain the availability of capital for new technology and innovation. The financial crisis may therefore reduce TFP growth in many rich countries. Some analysts also worry that future productivity growth in emerging economies will be curbed by slower growth in world trade and capital flows. But Mr Cates argues that healthier domestic balance-sheets in most emerging economies, along with continued rapid adoption of old and new technologies, should support robust productivity gains. He thinks that China, India, Indonesia and Brazil look particularly well placed. China’s surge in infrastructure spending will also help.

That said, even if China’s productivity growth remains faster than that of the developed world, it is likely to slow unless the government pushes ahead with bolder reforms. China’s growth is still too capital-intensive. Opening up the service sector to private firms and making it easier for workers to shift from rural to urban areas would result in a better allocation of labour and capital. That would help sustain rapid growth but would also make it more job-intensive. The resulting fall in labour-productivity growth might cause alarm among some analysts, but TFP would remain strong.

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Answers to

Mid-Term Exam-2008

Global Economic Environment of the Firm Name: ___________________________________ Section: _________________________________

INSTRUCTIONS:

1. By signing this exam, you state that you have followed the Fuqua honor code in solving this exam.

2. You have one hour and thirty minutes to complete this exam. This is a

closed-book, closed-notes exam.

3. All the articles are at the end of this exam.

4. In answering the questions, be specific in using the material in the course. You will be graded depending on how well you integrate the material from the course into your answers.

Total Points: 100

1. (25 points) Read Article 1, New Limits to Growth Revive Malthus Fears --- Spread of Prosperity Brings Supply Woes; Slaking China’s Thirst and answer the following questions. The article discusses the importance of an abundance of natural resources, such as oil, water, and land, in sustaining long-term growth. Specifically, the article argues that limits to the supply of natural resources, in the face or rising demand, could significantly lower growth. Use the framework developed in class to examine this argument. Please answer the following questions. (a) Historically, what is the engine for long-term growth? Explain how the evidence supports your claim. Historically, the engine for growth has been continuous improvement in Total Factor Productivity (TFP). For the developed countries such as the U.S., TFP has been rising at a rate of approximately 1.3% per year, which translates into a 1.3% per year growth in output per worker if the capital stock is held fixed. Since capital per worker will also rise in response to a rise in TFP, output per worker will rise by somewhat more than 1.3% per year. Due to diminishing returns, high growth rates in output per worker cannot be sustained by accumulating capital without improvements in TFP. (b) How is the engine for growth affected by natural resources? TFP captures any effect on production except the accumulation of capital and labor. Since natural resources (such as oil) are needed to produce goods and services, limits to the supply of natural resources will hamper continued growth in TFP. The supply of natural resources could be limited to any one country due to the demands for natural resources from other countries. (c) How can limitations in the supply of oil put a damper on long-term growth? What can be done to ease this problem? As just mentioned, limits to the supply of oil could put a damper on the sustained growth of TFP. Since TFP is the engine for long-term growth, limits to the supply of oil could limit long-term growth as well. The only way to ease this problem is to reduce the reliance on oil, either by using oil more efficiently, or by substituting away from the use of oil altogether.

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2. (25 points) Read Article 2 (Graphs), which contains graphs from the International Monetary Funds’ World Economic Outlook, and answer the following questions. (a) Using the arguments in class, explain the behavior of China’s current account from 1982 in terms of savings and investment. Why is China running such a huge current account surplus since 2002? Also, how is this related to China’s international holdings of assets such as U.S. Treasury Securities? From the early 1980s to the early 1990s, China frequently ran a current account surplus because of a steady rise in savings, even though investment remained fairly steady. In the early 1990s China’s investment surged, which led to a current account deficit during part of this time. From the mid 1990s to the late 1990s the investment rate in China fell. Savings fell too, but not by as much, to China began to experience a current account surplus. Beginning in 2000, China’s investment surged. However, due to the greater surge in savings, China’s current account remained in surplus. (b) From what you learned in class, regarding the current account, is China’s behavior typical of an emerging country? What is the typical behavior regarding the current account for an emerging country? Does an emerging country on net tend to supply goods to the rest of the world or absorb goods from the rest of the world? China’s behavior prior to 2000 is typical of an emerging country, but its large current account surpluses after 2000 are not typical of an emerging country. Typically, as a country begins to growth, it will important capital from the rest of the world and run a current account deficit.

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3. (25 points) Read Article 3, India rides growth wave into new age of tech globalization and answer the following questions. (a) The article documents continued development of IT in India. Explain the concept of comparative advantage and why continued development in IT in India is important to maintaining a comparative advantage in this sector. How is this issue related to rising wages throughout India? India will have a comparative advantage in IT if its productivity in IT exceeds the productivity in other sectors in India by a wider margin that this similar productivity gap in other countries. As productivity in other sectors rises, for India to maintain in comparative advantage in IT, it will be important for India to significantly raise its productivity in IT. Since rising productivity in all sectors in India will lead to a rise in wages, in order for India to maintain its comparative advantage in India, its productivity rise in IT will have to equal or exceed the rise in wages. (b) The article describes that Egypt is one of the lowest cost providers of IT in the world. Exactly what does this mean, in terms of comparative advantage and unit labor cost? The article also mentions various reforms in Egypt that are facilitating economic growth. Relate this to our discussion in class regarding the importance of openness in facilitating growth. That Egypt is a low cost provider of IT means that its productivity in IT is high relative to wages paid in IT. Unit labor cost is wages relative to productivity, so comparative advantage in IT means low unit labor cost in IT. As we have seen in class, the following features promote growth: raising education standards, a policy of openness (i.e., low taxes and other restrictions on trade), high quality institutions, and the protection of private property rights. It seems Egypt has begun to implement some of these reforms, which has allowed the investment in skills that lead to a comparative advantage in sectors such as IT.

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4. (25 points) Read Article 4 (Graph) and answer the following questions. (a) The graph shows falling income inequality in the U.S. from 1913 to the early 1980s, and rising income inequality following the early 1980s. Following on the discussion in class, offer an explanation of this phenomenon. Falling income inequality from 1913 to the early 1980s in the US could be due to the improvement in production processes (such as the assembly line, etc.) that raises the return to labor of the relatively unskilled labor. This rise in productivity leads to a rise in the wage rate of the relatively unskilled, and hence leads to falling income inequality. Also, during this time the US experienced a dramatic rise in educational attainment. This increased supply of skilled workers should lower the relative wage rate of skilled workers. The rise in the number of skilled workers continued past the early 1980s, so following the early 1980s an explanation of rising income equality is skilled-biased technical change. Essentially, investments in IT raise the productivity of skilled workers more so that unskilled workers, thereby leading to a rise in the skill premium and income inequality. (b) The graph also shows no significant rise in income inequality in the U.K. or France following the early 1980s. Using the tools we developed in class, provide an explanation as to why there was no rise in income inequality in the U.K. and France. Contrast this experience to the U.S. What are the implications of overall growth for your explanation? One explanation for the lack of a rise in income inequality in the UK and France is the lack of skilled-biased technical change. This could be due to the lack of IT investments at the extent of such investments in the US. The lack of such a driver of income inequality could also explain the lower overall rates of growth in the UK and France during this time period.

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Article 1

New Limits to Growth Revive Malthusian Fears --- Spread of Prosperity Brings Supply Woes; Slaking China's Thirst By Justin Lahart, Patrick Barta and Andrew Batson 2558 words 24 March 2008 The Wall Street JournalA1 English (Copyright (c) 2008, Dow Jones & Company, Inc.)

Now and then across the centuries, powerful voices have warned that human activity would overwhelm the earth's resources. The Cassandras always proved wrong. Each time, there were new resources to discover, new technologies to propel growth.

Today the old fears are back.

Although a Malthusian catastrophe is not at hand, the resource constraints foreseen by the Club of Rome are more evident today than at any time since the 1972 publication of the think tank's famous book, "The Limits of Growth." Steady increases in the prices for oil, wheat, copper and other commodities -- some of which have set record highs this month -- are signs of a lasting shift in demand as yet unmatched by rising supply.

As the world grows more populous -- the United Nations projects eight billion people by 2025, up from 6.6 billion today -- it also is growing more prosperous. The average person is consuming more food, water, metal and power. Growing numbers of China's 1.3 billion people and India's 1.1 billion are stepping up to the middle class, adopting the high-protein diets, gasoline-fueled transport and electric gadgets that developed nations enjoy.

The result is that demand for resources has soared. If supplies don't keep pace, prices are likely to climb further, economic growth in rich and poor nations alike could suffer, and some fear violent conflicts could ensue.

Some of the resources now in great demand have no substitutes. In the 18th century, England responded to dwindling timber supplies by shifting to abundant coal. But there can be no such replacement for arable land and fresh water.

The need to curb global warming limits the usefulness of some resources -- coal, for one, which emits greenhouse gases that most scientists say contribute to climate change. Soaring food consumption stresses the existing stock of arable land and fresh water.

"We're living in an era where the technologies that have empowered high living standards and 80-year life expectancies in the rich world are now for almost everybody," says economist Jeffrey Sachs, director of Columbia University's Earth Institute, which focuses on sustainable development with an emphasis on the world's poor. "What this means is that not only do we have a very large amount of economic activity right now, but we have pent-up potential for vast increases [in economic activity] as well." The world cannot sustain that level of growth, he contends, without new technologies.

Americans already are grappling with higher energy and food prices. Although crude prices have dropped in recent days, there's a growing consensus among policy makers and industry executives that this isn't just a temporary surge in prices. Some of these experts, but not all of them, foresee a long-term upward shift in prices for oil and other commodities.

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Today's dire predictions could prove just as misguided as yesteryear's.

"Clearly we'll have more and more problems, as more and more [people] are going to be richer and richer, using more and more stuff," says Bjorn Lomborg, a Danish statistician who argues that the global-warming problem is overblown. "But smartness will outweigh the extra resource use."

Some constraints might disappear with greater global cooperation. Where some countries face scarcity, others have bountiful supplies of resources. New seed varieties and better irrigation techniques could open up arid regions to cultivation that today are only suitable as hardscrabble pasture; technological breakthroughs, like cheaper desalination or efficient ways to transmit electricity from unpopulated areas rich with sunlight or wind, could brighten the outlook.

In the past, economic forces spurred solutions. Scarcity of resource led to higher prices, and higher prices eventually led to conservation and innovation. Whale oil was a popular source of lighting in the 19th century. Prices soared in the middle of the century, and people sought other ways to fuel lamps. In 1846, Abraham Gesner began developing kerosene, a cleaner-burning alternative. By the end of the century, whale oil cost less than it did in 1831.

A similar pattern could unfold again. But economic forces alone may not be able to fix the problems this time around. Societies as different as the U.S. and China face stiff political resistance to boosting water prices to encourage efficient use, particularly from farmers. When resources such as water are shared across borders, establishing a pricing framework can be thorny. And in many developing nations, food-subsidy programs make it less likely that rising prices will spur change.

…

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Article 2 (Graphs)

China's current-account balance 1982-2006

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Article 3

India rides growth wave into new age of tech globalizationRichard Wallace, Sufia Tippu. Electronic Engineering Times. Manhasset: Feb 25, 2008. , Iss. 1515; pg. 12, 2 pgs Copyright CMP Media LLC Feb 25, 2008

No longer simply an epicenter of outsourcing, India is riding a new wave of globalization as the economics of the technology business turn it into a regional design and development hub. The subcontinent is seeing an explosion of business and forging IT partnerships with neighbors as diverse and disparate as China, Egypt, Pakistan, Australia and Dubai, as these and other would-be technology players strive to usher in a new phase of tech-driven development to the region, which includes North Africa, the Middle East and the Gulf states.

This new geotechnology axis is destined to have a profound impact on the global IT and technology sectors, and its arrival marks a turning point in the shift of the industry's balance of power from West to East. "We are seeing a whole new age of globalization today," according to analysts at Bengaluru-based Prayag Consulting. "Three countries that are taking full advantage of this paradigm shift are Israel, China and India."

As India extends its connections throughout Asia, Australia, the Middle East and Africa, it will emerge not just as the region's business and technology leader, but as a more powerful player in the global IT sector. That will have a ripple effect on the entire market as next generation semiconductor and system development-including embedded-systems design-follows trends that arise from the burgeoning domestic and regional economies.

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With a GDP growing at 7.2 percent per year and a mobile-phone growth rate of 50 percent per year, Egypt also boasts one of the region's lowest IT outsourcing cost structures-lower than Eastern Europe's-including the world's lowest telecom costs. The nation is undergoing tax, customs and financial sector reform, and has a talent pool consisting of 300,000 graduates with strong commercial, engineering and science backgrounds. Its unique multilingual heritage with English, French, German, Italian and Spanish language skills also works in Egypt's favor. Multinational investors active there include Mentor Graphics, Oracle, Vodaphone, IBM, Microsoft and Sun Microsystems.

....

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Article 4 (Graph)

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Answers to

Mid-Term Exam-2007

Global Economic Environment of the Firm Name: ___________________________________ Section: _________________________________

INSTRUCTIONS:

1. By signing this exam, you state that you have followed the Fuqua honor code in solving this exam.

2. This is a take-home mid-term exam. You may use any published

resource to complete the exam, including your course notes. You may not interact in any way with another person to complete the exam.

3. All the articles are at the end of this exam.

4. In answering the questions, be specific in using the material in the

course. You will be graded depending on how well you integrate the material from the course into your answers.

5. Please limit your answers to at most one single-spaced page per

question (and hopefully less). You may handwrite the answers if you wish. You do not need to repeat the question in your answer sheet, and do not print the articles.

6. You can spend as much time as you wish to complete the exam, but it

should not take you more than 3 hours to complete.

7. Please hand in your exam at the beginning of class on Monday, November 19, 2007.

Total Points: 100

1. (25 points) Read Article 1, Running Fast and answer the following questions. (a) The article discusses the importance of technology for long-term growth. Please state as clearly as possible why technology is important for long-term growth in per-capita income. Why is it not possible for the accumulation of capital and labor alone to explain growth in per-capita income? As much as possible, use concepts and data that were presented in class. Output can rise because of an increase in productivity, capital, or labor. Due to diminishing returns, an increase in capital leads to an ever falling return to capital. Hence, an increase in capital cannot sustain growth in the long term. An increase in labor will attract more capital, and together will increase output in proportion to the rise in labor. However, this increase in overall output does not lead to a rise in output per worker, and hence cannot lead to a sustained rise in per-capita income. In contrast, a sustained rise in productivity leads to a sustained rise in per-capita income. (b) In class, we discussed the importance of openness for the adoption of technology. Why is this issue relevant to the growth of China? Historically, how have relatively poor countries been able to accelerate their growth so as to begin to catch up to the per-capita income levels of developed countries? China is relatively poor in part because of the use of old technologies. In order to achieve the per-capita income of developed countries, China needs to adopt best-practice technologies of the developed countries. To adopt ideas and technology from the rest of the world, China needs to open itself up to the rest of the world. Historically, poor countries that have not adopted open policies have not been able to growth fast, and hence have either not caught up or have fallen further behind developed countries. Poor countries that have adopted open countries have tended to grow fast and have closed the income gap with developed countries. 2. (25 points) Read Article 2, Strong October Jobs Growth Sends Another Mixed Signal on Economy, and answer the following questions. (a) The article mentions that much of recent strength in the U.S. economy is in the service sector. Given the discussion we had in class, how does this relate to productivity trends in the U.S. economy since the 1990s. In

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discussing this issue, discuss the relative importance of the service sector in a developed economy. The US has exhibited strong growth since the 1990s. This growth has been associated with strong productivity growth, which seems due to investments during this time period in IT. IT investment in the service sector in particular has lead to strong growth in the service sector. Growth in the service sector is important for the US as almost 80 percent of employment is in the service sector. (b) During the course we discussed the concept of comparative advantage. Explain the concept of comparative advantage. How could trends in the global economy help explain the relatively strong growth of the service sector in the U.S. Relative to Country B, Country A has a comparative advantage in producing Good 1 over Good 2 if the ratio of productivity in producing Good 1 relative to Good 2 in Country A is greater than this ratio in Country B. If IT investment in the service sector has increased the productivity in the service sector in the US, then the US would have acquired a comparative advantage in the service sector relative to the manufacture sector. As a result, an optimal allocation of global resources would be for the US to allocate resources to the service sector and away from the manufacture sector, thereby importing on net manufacture goods and exporting on net service goods. This indeed matches recent trade data for the US. 3. (25 points) Read Article 3, As Oil Price Sets New High, Stress Hits Developing Nations—Fuel Shortages, Unrest Spur Beijing to Act; Market Turning Point? and answer the following questions. (a) Explain how rising oil prices stemming from an increased demand for oil in China and other developing countries can affect developed countries. What should happen to employment, wages, and investment? Why? Rising oil prices will reduce the quantity of oil used in developed countries, and will thereby lower the productivity of capital and labor. The reduced productivity will lead to a leftward shift of the demand for labor and thus lower employment and wage. The reduced productivity will also lead to a leftward shift of the demand for investment and thereby also reduced investment.

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(b) What effect should the rising price of oil have on the current account of developed countries? Why? What effect should the rising price of oil have on the current account of oil exporting countries? Why? Are your two answers consistent? Developed countries would be paying more for the oil that is imported, thereby leading to a current account deficit. Recall that an outflow of payment for goods is a deficit entry on the current account. In contrast, an oil exporting country receives greater payment for exports of oil, thereby leading to a current account surplus. 4. (25 points) Take a look at “4. Graphs of the Current Account and Net Foreign Assets” and answer the following questions. Note that these graphs include predictions of the current account until 2011. (a) Given the discussion we had in class, provide an explanation as to why the US has such large current account deficits. To answer this question, you must compare the US to the rest of the world. The US has had relatively strong productivity growth since the 1990s. Also, in comparison to many other countries in the world, the US is a safe place to invest, especially given its political stability, highly-regarded rule of law, and high quality institutions. Consequently, the US has become a relatively attractive place to invest, and is expected to be so for some time. This explains the large and persistent current account deficits for the US. (b) As reflected in the second graph, the Net Foreign Assets position in the US is becoming large and negative. Why? Also, what does this imply about international lending and borrowing. Who is borrowing and who is lending? A current account deficit also reflects a capital financial account surplus. That is as relatively more goods are imported, relatively more financial assets are sold to pay for these goods. The sale of financial assets leads to a fall in the net stock of foreign assets. This means that the US is borrowing from the rest of the world to finance its net imports of goods and services.

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Article 1

Running fast Nov 8th 2007 From The Economist print edition

China and India have much to offer the world of technology, argues Simon Cox (interviewed here), but more still to gain from it TOWARDS the end of the 11th century, while tardy Europeans kept time with sundials, Su Sung of China completed his masterpiece: a water clock of great intricacy and accuracy. Standing almost 12 metres (40 feet) tall, Su's “Cosmic Engine” wavered, it is said, by only a few minutes in every 24 hours. From twin tanks filled by servants, a steady flow of water was cupped and spilled by a series of buckets mounted on a wheel. The rotation of the wheel turned the clock, as well as an astronomical sphere and globe that charted the movement of the sun, moon and planets. Drums beat 100 times a day; bells chimed every two hours. A replica, painstakingly built with contemporary methods, now turns in Taiwan's National Museum of Natural Science.

Clockmaking was only one scientific endeavour in which China and India comfortably led the world before the 15th century. China outstripped Europe in its understanding of hydraulics, ironsmelting and shipbuilding. Its machines for ginning cotton, spinning ramie and throwing silk seemed to lack only a flying shuttle and a drawbar to match the 18th-century contraptions that launched Britain's Industrial Revolution. Clean your teeth with a toothbrush, rebuff the rain with a collapsible umbrella, turn a playing card, light a match, write, pay—or even wipe your behind—with paper, and you register a debt to China's powers of invention.

India's genius, then as now, was in software not hardware. Its ancient civilisations ushered in a “mathematical revolution” from the fifth century, when Aryabhata devised something like the decimal system. In the seventh century Brahmagupta explained that a number multiplied by zero was zero. By the 15th century, Madhava had calculated pi to more than ten decimal places.

After the 15th century, however, the technological clock stopped in both countries, even as it accelerated in Europe. This peculiar loss of momentum, noted Joseph Needham, a great historian of Chinese science, takes some explaining. Why, he asked, did the science of Galileo emerge “in Pisa but not in Patna or Peking”?

In his book “The Lever of Riches”, Joel Mokyr settles on a simple explanation for China's technological stagnation: the country's imperial state lost interest. Its purposes were better served by continuity than by progress, and there was no rival source of power and patronage to pick up the threads it dropped. Roddam Narasimha of India's National Institute of Advanced Studies reaches a similar conclusion for India. “Up to the 18th century, the East in general was strong and

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prosperous, the status quo was comfortable, and there was no great internal pressure to change the global order,” he writes.

That diffidence no longer hampers either state. Both China and India are now restless with technological ambition. China's government does not have the luxury of choosing between progress and stability; it cannot enjoy social peace without economic advance. For the past 30 years it has tried to turn the clock forward. By 2015 its research scientists and engineers may outnumber those of any other country. By 2020 it aims to spend a bigger share of its GDP on research and development (R&D) than the European Union.

India, for its part, surveys the future with uncharacteristic optimism. Its technological confidence has grown immeasurably thanks to the success of its software and IT firms. The heirs to Aryabhata and Brahmagupta, India's digital ambassadors have won acclaim for their mastery of ones as well as zeros.

But even as India's technological powers make a splash in the world, they stir only the surface of its own vast society. India produces more engineering graduates than America. But it has only 24 personal computers for every 1,000 people, and fewer than three broadband connections. India's billion-strong population cuts both ways. Whenever an Indian demographic appears as a numerator, the resulting number looks big. But whenever its population is in the denominator, the number looks small. It is like looking at the same phenomenon from opposite ends of a telescope. As of now, India matters more to technology than technology does to India.

This is a pity. India and China still have more to gain from the adoption and assimilation of technology than from invention per se. Some of their best minds are adding generously to the world's stock of knowledge, but the more urgent task for the countries themselves is to make wider use of know-how that already exists. Indeed, the World Bank has calculated that India could quintuple the size of its economy if it only caught up with itself—that is, if the mediocre firms in its industries closed the gap with the best. Both countries miss out when policies to promote invention, such as China's push for “indigenous” innovation or India's recent patent laws, serve to stymie diffusion.

A year in China, foreign residents say, is like ten years outside. Its clock is already turning rapidly. But the cogs and levers that drive technological progress are as intricate and delicate as Su Sung's mechanism. China's government is in danger of trying to do too much. Its monumental efforts to educate and train have filled the tanks of its innovation engine. Now it is time for it just to let the water flow.

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Article 2

Strong October Jobs Growth Sends Another Mixed Signal on Economy By Sudeep Reddy 1012 words 3 November 2007 The Wall Street JournalA1 English (Copyright (c) 2007, Dow Jones & Company, Inc.)

A surprising surge in October payrolls suggested a U.S. economy running at two speeds -- with strength in the service sector offsetting weakness from a plummeting housing sector and gyrating credit markets.

Employers added 166,000 jobs in October, the Labor Department said, the most in five months. The unemployment rate remained unchanged at 4.7% despite widespread worries that the odds of a recession are rising.

"Parts of the economy are fraying, but the labor market hasn't broken," said J.P. Morgan economist Haseeb Ahmed.

Friday's report capped a week of conflicting signals. Earlier in the week, the government said the economy grew at a robust 3.9% pace in the third quarter, helped by surging exports. Yet consumer confidence fell, and a survey of purchasing managers suggested a loss of momentum for manufacturers.

Credit-market worries, meanwhile, reemerged due to troubles at major banks, leading to a sharp sell-off in stocks; the Dow Jones Industrial Average rose 27.23 to close at 13595.10 on Friday, but for the week was off 1.5%, or 211.60. Crude oil continued its steady rise, with the benchmark crude-oil futures price up $2.49 to $95.93 a barrel on the New York Mercantile Exchange, another new nominal high. Gold futures smashed $800 an ounce, hitting $810.70 an ounce, and recently traded at $807.90.

The Federal Reserve cut its key interest rate by one-quarter percentage point this past week, citing its expectation that the economy "will likely slow in the near term," and signaled its reluctance to cut rates again. But even after the upbeat employment report, financial markets continue to anticipate another quarter-point rate cut in December. "One day you see financial turmoil and financial markets going crazy, and the next day you see a number of good jobs being created. It makes you much less certain about what [the Fed] needs to do," said Brian Fabbri, BNP Paribas's chief economist for North America.

Friday's cheery employment headlines didn't dispel many economists' diagnosis that that the U.S. economy is slowing significantly, pulled down by a persistent decline in housing construction and housing prices. The volatility in financial markets continues to create unease. "It's those abysmal sectors that are going to create more financial problems, and those financial problems are going to feed back into the economy and create more weakness ahead," said Mr. Fabbri, who, like many other forecasters, expects fourth-quarter growth of between 1% and 1.5%.

Many forecasters expect weaker consumer spending to push growth lower. Paul Ashworth, an economist at Capital Economics Ltd., a London-based research firm, said the economy faces the risk of contracting due to plummeting consumer confidence, higher oil prices and the effects of the housing downturn. "I'd probably characterize the October payroll figures as the last hurrah," he said.

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The International Monetary Fund's new chief, Dominique Strauss-Kahn called the jobs numbers "much more than expected," but said no recent developments in the global had changed the IMF's view that the U.S. economy would slow in 2008, but avoid recession. "There is no evident signal that it [U.S. economy] will go further than a slowdown," he told reporters.

Much of October's payroll increase came in restaurants, leisure and hospitality, education, health and professional business services. Payrolls fell in manufacturing and construction and in housing-related finance, though finance as a whole added jobs.

Temporary employment, sometimes seen as a leading indicator of overall job trends, rose as well after declining since February. Temp agencies had been struggling all year, depending on growth abroad to offset weak U.S. results.

Adecco SA, the world's largest temp-employment firm, said Friday that third-quarter world-wide revenues rose 2% while revenue in the U.S. and Canada dropped 8%. "We don't see a recession in the U.S.," Chief Executive Dieter Scheiff told investors. "And we continue to see solid growth rates in Europe and Asia."

A seasonally adjusted drop in payrolls among retailers could portend caution heading into the holiday shopping season. OfficeMax, for instance, reported disappointing earnings growth this past week, and CEO Sam Duncan said the firm would slash costs and adjust its promotional plans "in light of more cautious shopping trends by retail consumers and small businesses."

"This is supposed to be, like, the worst holiday season in four or five years, and that concerns us," he said on a conference call.

Average hourly earnings of production and non-supervisory rose just 0.2% in October, the smallest increase since March, a sign that households may not have as much to spend in coming months, but economists said that reading may have been distorted because a large number of jobs added in October were lower-wage jobs. Hourly earnings are up 3.8% from a year ago. The Labor Department's measure of the total number of hours worked in the economy is running 1.5% ahead of last October, an increase but significantly slower than the 2.6% increase in the previous 12 months.

The jobs report is subject to substantial revisions; the report on August employment initially showed a drop of 4,000 jobs, which is now estimated to be a gain of about 93,000. The government now says employers added 96,000 jobs in September, down 14,000 from its initial estimate. Job gains of about 100,000 a month, given current demographics, are generally considered enough to keep the unemployment rate steady.

But Dean Baker. co-director of the Center for Economic and Policy Research, a left-leaning Washington think tank, noted that October marked another month in the ongoing decline in the fraction of the population working, now at 62.7%. "This drop is being driven by younger workers, as people over age 55 continue to work in growing numbers," he said.

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Article 3

As Oil Price Sets New High, Stress Hits Developing Nations --- Fuel Shortages, Unrest Spur Beijing to Act; Market Turning Point? By Shai Oster in Beijing, Patrick Barta in Bangkok and Russell Gold in Austin, Texas 1930 words 1 November 2007 The Wall Street JournalA1 English (Copyright (c) 2007, Dow Jones & Company, Inc.)

One of the biggest forces behind the near-quadrupling of oil prices this decade has been voracious fuel demand in China and other developing nations. But with crude closing in on $100 a barrel, shortages and price spikes are sparking economic and social tensions from Beijing to Tehran. That stress could signal a turning point in the long-running energy boom.

Yesterday, China announced an almost 10% increase in domestic gasoline and diesel prices, in a dramatic move to tamp down demand. China's price move, reducing its need for subsidies to oil firms, was seen by analysts as an attempt by authorities to cope with an energy market run amok. Supply shortfalls have been triggered by the country's combination of subsidized energy prices and breakneck economic growth, which has led to insatiable fuel demand.

Over the long haul, China's move should help curb demand and thus could eventually act as a brake on global prices. But first, it will likely increase demand. Chinese refineries have faced such unattractively low government-set prices for their gasoline and diesel that they have held back from buying crude; now, the new higher prices give them an incentive to snap up more crude to make more gasoline and alleviate the shortages.

In fact, within hours of China's announcement, crude oil set yet another record high on the New York Mercantile Exchange, closing at $94.53. Crude rose above $95 early in after-hours trading, bearing in on the inflation-adjusted high of $101.80 in April 1980.

Scarcities of diesel fuel are being reported in regions throughout China, forcing truckers to line up for supplies. The severity of the problem was further underscored by shortages in the capital of Beijing, which is traditionally kept well supplied. Several gas-station managers in the city's suburbs said they had run out of some types of diesel and were rationing others.

Officials say the situation could worsen if not quickly resolved. A man was killed Tuesday morning after jumping a line to buy gasoline in the Henan Province city of Xinyang, local police said.

China isn't the only developing nation to wrestle with the problems caused by fuel subsidies in a time of rising oil prices. As governments have begun to unwind fuel subsidies, people have taken to the streets to protest from Katmandu, Nepal, to Conakry, Guinea.

Over the summer, the Iranian government raised gas prices by 25%, then began fuel rationing. Protests erupted in Tehran, with several gas stations being torched.

More recently, the decision in August by Myanmar's military government to increase fuel prices -- doubling the price of diesel overnight -- led to protests in Yangon. This sparked widespread antigovernment demonstrations and a brutal crackdown when the military began shooting at civilians and arresting Buddhist monks.

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Elsewhere, fuel protests have cropped up in Yemen, Iraq and Indonesia -- often leading governments to quickly reinstate subsidies. India and Indonesia have ruled out any fuel hikes soon.

But China's moves have the biggest impact. Without China's growing thirst for oil, world oil demand would be growing only moderately. Over the past five years, Chinese oil consumption has grown at an 8.7% annual rate. The rest of the world has grown at an annualized rate of 1.5%.

China's current consumption of 7.6 million barrels of oil a day represents 9% of world oil output, according to the International Energy Agency, the Paris-based energy watchdog for industrialized countries. Five years ago, China consumed just 6.4% of world output.

China heavily subsidizes fuels in its domestic market, a big reason that fuel consumption has kept rising briskly there even as world oil prices climbed into the stratosphere. Yesterday's move raises the prices of gasoline, diesel oil and aviation kerosene by 500 yuan, or about $67, per metric ton for wholesale prices. But even after the increase, the Chinese will pay approximately $2.50 to $3 a gallon for diesel and gasoline.

By comparison, U.S. drivers pay an average of $3.23 a gallon for diesel and $2.90 a gallon for gasoline, according to AAA. And in Europe, where fuels are heavily taxed, motorists pay upwards of $5 a gallon for both fuels.

"The adjustment was made to shorten the gap between highflying international crude prices and domestic oil prices," said China's economic planner, the National Development and Reform Commission, according to the Xinhua news agency. China last raised fuel prices in May 2006. Since then, international oil prices have risen about 30%.

Previous changes were telegraphed weeks in advance. Up until recently, the government was saying it liked the idea of raising energy prices to encourage fuel efficiency, but insisted that its hands were tied because inflation was already going up too quickly.

Yesterday's step thus came as a surprise, but doesn't go far enough to cure China's basic problem. If China doesn't fully liberalize fuel supplies and let prices rise, it could face even-worse energy-supply bottlenecks. Tuesday's queue-jumping killing may offer a preview of the social unrest that long waits at the pump could spur.

But China is in a bind because rising fuel prices could also heighten societal pressures. The country's leadership has made a key issue of addressing the growing gap between China's swelling ranks of urban rich haves and usually rural have-nots. The poor and middle class are already reeling from soaring prices of staple foods.

In August, Premier Wen Jiabao visited a pig farmer to highlight his concern about the rising cost of meat. A big jump in fuel prices, especially diesel, would hit rural farmers especially hard. Their incomes continue to lag far behind salaries in cities like Shanghai or Beijing, and Chinese leaders worry a bigger gap could eventually spark social instability or even threaten the Communists' grip on power.

Rising oil prices could yet derail the still-booming Asian economy. Countries there have widely used fuel subsidies to spur strong economic growth. But cheap fuel also distorts demand and discourages consumers and industry from being efficient. The McKinsey Global Institute, the consulting company's economics-research outfit, estimates that "ending fuel subsidies worldwide would cut demand for transportation fuels by three million barrels a day." That's equal to roughly 3.4% of daily use.

Moreover, the subsidies come at a steep cost to governments, and they can create distortions that stress the broader economy. In 2005, for instance, Indonesia's currency and equity markets nose-dived amid concerns over whether the government could continue to foot the bill for its big subsidies.

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Pressure has been growing on China's government to raise its low, state-set fuel prices to offset losses to its refiners because of the higher costs of oil. The inflation-wary government has forbidden them to pass on increased production costs to consumers, despite the widening gap between domestic and global diesel prices.

The problem is mostly limited to diesel fuel, which outsells gasoline because it is used for trucking and farming, while China's gasoline-fueled private car market is still relatively small. With the harvest season over, most buyers are truckers, who play a key role in the vast logistics network that feeds China's export juggernaut. With winter fast approaching, the trucks also play a big role in transporting the coal needed to keep cities warm.

Shortages are more severe in the south, where they first began to appear in recent weeks. According to Sui Jingwen, general manager of China Cargo Alliance, the supply gap could affect domestic trade, especially for food and goods. "Fruit in the south needs to be transported to the north, and grain from the north needs to be taken to the south," Mr. Sui said.

China has given the country's biggest refiner, China Petroleum & Chemical Corp., known as Sinopec, big subsidies at the end of the past two years to offset its losses.

The supply shortfall underscores the rising importance of independent oil refiners and gas stations, which supply an estimated 5% to 10% of China's market. These smaller companies are more vulnerable to fluctuations in international prices than the two state-owned oil companies that dominate China. Smaller refiners don't get government support. So, they have been willing to stop production completely rather than keep selling at the state-set prices -- which meant selling at a loss.

The impact of surging oil prices hasn't been uniform. PetroChina Corp., China's biggest oil producer, has benefited from the rising prices because it can sell its own crude oil. Harder hit has been Sinopec, which has to buy about 75% of the crude oil it uses to make fuel.

Because of its special role in keeping China's tanks full, Sinopec has been basically forced by the government to make up for any shortfalls.

But some big players are suffering, too. Earlier in the week, Sinopec said it was under "tremendous" pressure from the rising prices. "We will try the best to ensure a stable supply of fuel in the market, but it's a big challenge for us," Sinopec's chief financial officer, Dai Houliang, told reporters Monday.

Elsewhere in Asia, the central-bank governor of Thailand and officials in Indonesia and Malaysia have spoken out in recent days about the potential for oil-based inflation. And Thai oil-and-gas conglomerate PTT PCL raised retail fuel prices by about one cent, to about $1 a liter depending on the grade of fuel, effective yesterday. Prices at PTT are considered to be a benchmark for Thailand's consumer market.

Speculation has mounted that Thailand's Finance Ministry will revise down the country's economic-growth forecast sometime this month after taking into account the recent rise in oil prices. Growth is expected to tally around 4% this year, relatively modest for Thailand.

Still, developing Asia is being cushioned somewhat by the recent rise in the value of its currencies, which makes average consumers feel wealthier and enables them to spend more on fuel. Several countries -- including India, Malaysia and Indonesia -- continue to subsidize consumer fuel prices, which further eases the pain for consumers. There is little evidence the countries can't afford to maintain those subsidies, at least for the time being.

In Indonesia, Energy Minister Purnomo Yusgiantoro recently said the government wouldn't raise fuel prices before 2009.

India's subsidies are believed to have cost $10 billion or more last year. Much of the cost is shared by domestic oil companies, including exploration and production giant Oil & Natural Gas Corp. Some

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firms deeply resent having to finance such extravagances. India is importing some 70% of its oil, and that percentage could increase in the coming years, leaving the country's oil companies particularly vulnerable if international prices keep rising.

Even so, the pressure to keep subsidies in place in India is great, especially as prices for food and other commodities have also climbed. In one indication of the political landscape, the Indian government recently promised not to raise retail prices of gasoline, diesel, cooking gas and kerosene oil.

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Kersten Zhang in Beijing, Ellen Zhu in Shanghai, Aries Poon in Hong Kong and Jun Yang in Singapore contributed to this article.

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4. Graphs of the Current Account and Net Foreign Assets

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Answers to

Mid-Term Exam-2011

MGRECON 301:

Global Economic Environment of the Firm

Professor John Coleman

Fuqua School of Business, Duke University

Name: ___________________________________

INSTRUCTIONS:

1. By signing this exam, you state that you have followed the Fuqua honor code in solving this exam.

2. You have two hours to complete this exam. This is a closed-book,

closed-notes exam.

3. All the articles, graphs, tables, etc., are at the end of this exam.

4. In answering the questions, be specific in using the material from this course. You will be graded depending on how well you integrate the material from this course into your answers.

Total Points: 100

2

1. (25 points) Read the excerpts under “1. Article” and answer the following questions.

(a) (15 points) The article mentions that “The rate of return on foreign

investment is higher in Africa than in any other developing region.” Explain this comment in the context of the global allocation of capital that we discussed in class. Can such a high rate of return persist for a while? In the absence of risk, investors will allocate capital around the world so that the return to their capital is the same in every country. Hence, under such a circumstance, all countries would offer the same return to capital. A country can only offer a higher return to capital for two reasons: (1) investors have not yet had sufficient time to take full advantage of higher rates of return in a country, or (2) there exists a risk premium for investing in a country so that investors demand a higher return from capital allocated to that country. Only the latter can persist for a significant length of time.

(b) (10 points) The article also discusses policy changes that have led to productivity growth. In general terms, discuss the importance of productivity for long-term growth and as well the importance of the right policies to sustain growth. Use concepts of total factor productivity, diminishing returns, growth accounting, and high-quality institutions in your answer.

A sustained rise in per-capita income can only be achieved by a sustained rise in total factor productivity. Due to diminishing returns, an attempt to grow by a sustained rise in the capital stock will not work. Each increment to the capital stock will lead to a smaller and smaller increment to output. Growth accounting decomposes output growth in growth in total factor productivity, growth in capital, and growth in labor. Such exercises reveal that most of the growth in per-capita output is accounted for by growth in total factor productivity. The right environment needs to exist for sustained growth in total factor productivity to take place, which includes having high-quality institutions. These institutions reward investors for activity that promotes productivity and profitability.

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2. (25 points) Read the excerpts under “2. Article” and answer the following question. The article discusses a relatively recent surge in service sector productivity in the U.S. Why is this important for the long-run sustainability of overall growth in the U.S.? Discuss this issue in the context of the structural transformation of an economy through various development phases. Poor countries tend to have most of their labor force in agriculture. As economies develop they tend to transition out of agriculture and into the industry and service sectors. At some point in the development process, they also tend to exit the industry sector and allocate almost all labor to the service sector. The U.S., for example, has about 80 percent of its labor allocated to the service sector. During the initial phases of growth it is important to sustain high rates of growth of productivity in the agriculture and industry sectors, as most employment is in these sectors. Later, as more and more labor is allocated to the service sector, it becomes very important to sustain productivity improvements in the service sector as well. Historically, it has been difficult to sustain productivity growth in the service sector, which is why the recent surge in productivity in the service sector in the U.S. is so important.

3. (25 points) Read the excerpts under “3. Article” and answer the following question. The article discusses rising income inequality in the U.S. and makes the point that rising income inequality is due to technology improving faster than education. Using ideas we developed in class, what is meant by this? How does this relate to global trends in income inequality?

A rise in education, especially basic education, leads to a rise in the wage rate of the relatively low wage earners, and hence leads to falling income inequality. A rise in technology tends to be biased towards skilled workers, and hence tends to lead to a rise in income inequality. The rising income inequality in the U.S. seems to be a reflection that the rate of technological progress dominates the effect of rising education on relative wages. We also tend to see rising income inequality in most regions around the world, which suggests too that the effect of technology is dominating the effect of education on relative wages in most countries.

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4. (25 points) Take a look at “4. Graph” and answer the following question. The graph shows that the Current Account in the U.S. rose during the recent recession and is falling now. Using concepts developed in class, explain these trends. In your explanation, clearly define the Current Account. As we enter the expansion, does the falling Current Account mean we are borrowing more from the rest of the word or loaning more to the rest of the world? What is happening to the U.S.’s Net International Investment Position (holdings of Foreign assets by U.S residents minus holdings of U.S. assets by foreigners).

The Current Account equals Savings minus Investment and reflects trade in current GDP. The Current Account falls when Investment rises faster than Savings. During an expansion there tends to be an investment boom. Although there is a rise in GDP, the associated rise in Consumption tends to dampen the rise in Savings. Consequently, the Current Account tends to fall during an expansion, as Investment rises faster than Savings during such times. Similarly, the Current Account tends to fall during a recession, as Investment falls faster than Savings. A falling Current Account means a country is on net importing more from the rest of the word, and hence is borrowing more to pay for these imports. As this country borrows, it sells its assets on net, and hence a Current Account deficit is associated with a fall in the country’s net international investment position.

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1. Article

What’s driving Africa’s growth The rate of return on foreign investment is higher in Africa than in any other developing region. Global executives and investors must pay heed. JUNE 2010 • Acha Leke, Susan Lund, Charles Roxburgh, and Arend van Wamelen Source: McKinsey Global Institute

Excerpts: … African governments increasingly adopted policies to energize markets. They privatized state-owned enterprises, increased the openness of trade, lowered corporate taxes, strengthened regulatory and legal systems, and provided critical physical and social infrastructure. Nigeria privatized more than 116 enterprises between 1999 and 2006, for example, and Morocco and Egypt struck free-trade agreements with major export partners. Although the policies of many governments have a long way to go, these important first steps enabled a private business sector to emerge. Together, such structural changes helped fuel an African productivity revolution by helping companies to achieve greater economies of scale, increase investment, and become more competitive. After declining through the 1980s and 1990s, the continent’s productivity started growing again in 2000, averaging 2.7 percent since that year. These productivity gains occurred across countries and sectors.

Promising long-term growth prospects

A critical question is whether Africa’s surge represents a one-time event or an economic take-off. … Today, individual African economies could suffer many disappointments and setbacks. While short-term risks remain, our analysis suggests that Africa has strong long-term growth prospects, propelled both by external trends in the global economy and internal changes in the continent’s societies and economies.

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2. Article

The Productivity Renaissance in the U.S. Service Sector

Andrew Sharpe Centre for the Study of Living Standards

International Productivity Monitor, Fall 2000

… after many decades of stagnant growth, there now appears to be a renaissance in service sector productivity [in the U.S.] Real … value added per person employed in the broadly defined service sector … advanced at a 2.4 per cent average annual pace in the 1995-98 period, up nearly five-fold from the 0.5 per cent rate of the 1981-89 and 1989-95 periods. It now appears that the service sector productivity drought is over, at least for the second half of the 1990s, and possibly into the future. This development may come as a surprise. Economists have long deplored lagging productivity growth in the service sector, and have advanced numerous explanations, including measurement problems, and an intrinsic lack of dynamism in many service industries. A[n] … explanation is that the massive investment in information technology (IT) made in the service sector throughout 1990s is finally paying off in terms of increasing output. The Solow productivity paradox seems to be resolved as we are now seeing the impact of computers in the productivity statistics. The lags between IT investment and productivity appear to have ended as firms and workers have now learned to use these new technologies in an effective manner. The large IT investment in wholesale and retail trade and the very strong increases in productivity support the IT story.

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3. Article

Business

ECONOMIC SCENE

Why Is Income Inequality in America So Pronounced? Consider Education By TYLER COWEN Published: May 17, 2007

The most commonly cited culprits for the income inequality in America —

outsourcing, immigration and the gains of the super-rich — are diversions from the

main issue. Instead, the problem is largely one of (a lack of) education.

The extent of outsourcing, for instance, is not yet high enough to have much effect on

American wages. Even if a call center is set up in India, this helps American business

expand at home. Most generally, the net flow of investment is into the United States,

not away from it. It appears that more American jobs are “in-sourced” than

outsourced.

For the economy as a whole, labor’s share of national income has stayed roughly

constant at just above 70 percent. What has changed is that highly skilled laborers

earn more labor income than low-skilled workers.

College graduates have been gaining relative to high school graduates. … Starting

about 1950, the relative returns for schooling rose, and they skyrocketed after 1980.

The reason is supply and demand. For the first time in American history, the current

generation is not significantly more educated than its parents. Those in need of

skilled labor are bidding for a relatively stagnant supply and so must pay more.

Income distribution thus depends on the balance between technological progress

and access to college and postgraduate study. … Technology is advancing faster than

our ability to educate.

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4. Graph

The Current Account in the U.S.