Questions & explanations
1. A city has three bus companies. Using a Logit model, the predicted market share for company A is 30% and for B is 20%. If a new company C enters, what does the IIA assumption imply about A's new share?
The IIA assumption implies that the ratio of A's share to B's share remains the same after C enters. So before entry, A/B ratio is 30/20 = 1.5. If the total market size is fixed, the new shares of A and B will be reduced proportionally. For example, if C takes 10% of the market, then A and B together now have 90% to split. The ratio 1.5 means A gets 1.5/2.5 * 90% = 54% of 90% = 48.6%? Wait, re-calc: A's new share = (30/(30+20)) * (100%-10%) = (0.6)*90% = 54%? That would be 54% of total, not consistent. Actually, after entry, total shares must sum to 100%. If C gets 10%, then A and B share the remaining 90% in the same ratio as before: A gets (30/50)*90% = 54%, B gets (20/50)*90% = 36%. So A's share jumps from 30% to 54%? That is unrealistic. This shows the IIA problem: a new bus company should take more from similar companies, not proportionally from all.
2. Compare Solow and endogenous growth on what policies can raise growth in the long run.
In Solow, policies that affect the saving rate (like tax incentives for investment) can raise the steady-state level of output, but they do not change the long-run growth rate. Only technological progress, which is external, raises long-run growth. In endogenous growth, policies that encourage R&D, education, and innovation can permanently increase the growth rate. For example, subsidies to research labs can lead to new ideas that keep output growing faster. Solow suggests that once the economy reaches steady state, more investment just maintains capital, not growth. Endogenous growth models give a bigger role to government in fostering knowledge. So endogenous theory implies active policy can boost growth forever, while Solow is more limited.
3. Compare first and second-generation crisis models: which better explains the 1997 Asian crisis?
The 1997 Asian crisis is often seen as a mix, but second-generation features were prominent. Countries like Thailand had some first-generation warning signs (large current account deficits, fixed exchange rates), but not huge budget deficits. The crisis was partly self-fulfilling: once investors lost confidence, they attacked, forcing devaluation. The high costs of defending (high interest rates hurting banks) made governments give up. So second-generation models, with multiple equilibria and contagion, fit better. However, first-generation factors (overvalued currencies, weak banking) played a role. Both models together give a fuller picture: fundamentals created vulnerability, but the timing and spread were driven by expectations.
4. How does endogenous growth theory differ from the Solow model?
Endogenous growth theory explains growth from inside the economy, not from outside technology. It says investment in human capital, innovation, and knowledge can have increasing returns, so growth can continue forever. Unlike Solow, there is no diminishing returns to capital if knowledge is included. For instance, education and research create spillovers that benefit all firms. The theory suggests that government policy (like R&D subsidies) can permanently raise growth rates. In Solow, policy only affects level of output, not long-run growth rate. Endogenous models also do not predict convergence; rich countries may stay rich by innovating. The key difference: growth is driven by purposeful actions, not external luck.
5. How does a second-generation currency crisis model differ from the first?
Second-generation models focus on self-fulfilling fears and multiple equilibria. Even if fundamentals are not bad, if speculators believe a devaluation is coming, they attack, forcing the government to devalue. The government weighs costs of defending the peg (high interest rates, recession) against benefits of keeping it. If defending is too costly, they let go. For example, the British pound in 1992 (Black Wednesday) was attacked despite okay fundamentals, because speculators thought the government would not keep rates high. Unlike first-generation, there is no steady reserve drain; the crisis can happen purely because of expectations. These models explain why some pegs collapse without obvious policy inconsistency.
6. What role does technology play in the Solow model? How is it different from capital?
In the Solow model, technology is an external factor that increases output without adding more capital or labor. It is called total factor productivity. While capital has diminishing returns, technology can raise output per worker continuously. Capital accumulation alone cannot sustain long-run growth because returns diminish; so technology is the engine of lasting growth. The model treats technology as exogenous (coming from outside the model). In contrast, capital is accumulated by saving and investment. For example, a new invention can double output from the same machines and workers. Without technology, the economy would stagnate in steady state. That is why long-run growth depends on technological progress.
7. List three key criteria for an optimal currency area (OCA). Why are they important?
Three key OCA criteria are: labor mobility (workers can move easily between regions), trade openness (high trade between regions), and fiscal transfers (a central budget to help regions hit by shocks). If these criteria are met, a shared currency works well because shocks can be absorbed without exchange rate changes. For example, the US dollar area works because Americans move freely for jobs and the federal government transfers funds to struggling states. Without these, a common currency can lead to asymmetric shocks and persistent unemployment. The Eurozone lacks strong fiscal transfers and labor mobility, causing problems for countries like Greece. The criteria help judge if a currency union is beneficial.
8. A firm sells a unique product with no close substitutes. In Bertrand competition with differentiated products, how would you model its demand?
If the product has no close substitutes, its demand is nearly independent of other firms' prices. In that case, the firm behaves like a monopolist for its niche. In the differentiated Bertrand model, the cross-price elasticity between this firm's product and others is very low. The firm's demand curve depends mainly on its own price. Profit maximization then involves setting price where marginal revenue equals marginal cost, similar to monopoly. However, if there are any distant substitutes, small cross effects remain. The model captures this by including other products' prices in the demand function with small coefficients. The firm still needs to consider competitors, but their impact is minimal.
9. Compare reactance with the door-in-the-face technique.
Reactance is a psychological reaction against pressure, while door-in-the-face is a persuasion tactic that uses an initial large request followed by a smaller one. Door-in-the-face works partly through guilt and reciprocity: after refusing a big request, people feel they should agree to a smaller one. Reactance is the opposite: it makes people push back against restrictions. However, door-in-the-face can trigger reactance if the first request feels too controlling. To avoid that, the requester should appear reasonable. Both techniques involve freedom: reactance fights to keep it, door-in-the-face uses a concession to gain compliance. They are different strategies with different emotional roots.
10. What is a mixed strategy Nash equilibrium?
A mixed strategy Nash equilibrium is a situation where each player chooses a random mix of actions (like flipping a coin) instead of a single fixed action. Players pick probabilities for each action so that no one can do better by changing their probabilities. This happens when there is no pure strategy equilibrium, where both players choose one action for sure. For example, in a penalty kick game, the kicker randomly kicks left or right, and the goalie dives left or right with probabilities that make each other indifferent. Each player's chosen probabilities are a best response to the other's probabilities. It is a stable outcome because neither player wants to change their random choice.
11. Define the steady state in the Solow model. Why does the economy reach it?
The steady state is a situation where capital per worker and output per worker stop changing over time. It happens when total investment equals depreciation (and population growth if included). If capital per worker is below steady state, investment exceeds depreciation, so capital grows. If above, depreciation exceeds investment, so capital falls. Diminishing returns ensure that eventually the extra output from new capital just covers depreciation. The economy reaches a stable point because each additional unit of capital adds less and less output. In steady state, growth per worker stops unless technology improves. The steady state level depends on the saving rate and population growth.
12. In Berry-Levinsohn-Pakes (BLP) demand estimation, what does the term 'random coefficients' mean and why is it important?
Random coefficients allow different consumers to have different preferences for product features. For example, some consumers care a lot about fuel efficiency, others about horsepower. In BLP, the coefficient on a feature like fuel efficiency is not the same for everyone; it varies randomly across consumers. This captures real-world taste heterogeneity. It is important because without it, the model would assume all consumers value features the same, which gives wrong substitution patterns. BLP estimates the distribution of these coefficients, so it can predict how demand changes when a product's features change. This makes the demand estimates more accurate for differentiated products.