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ECON 2002

ECON 3870


ECON 4807/5807

Scholarship in Comparative Economics




Department of Economics






Welcome to Comparative

Economic Systems, ECON

3870, in Summer Session


July-August, 2014.

The Final Exam is below,

followed by the final exam

 answer key.

The Class Assignment is

 below the final exam,

followed by the

 answer key to the Class


This is followed by the

midterm exam and answer

key.  The midterms and class

assignments have been

returned to the CUOL Student

 Centre, D283 Loeb.  I retain

the final exam.


Most readings for this course, other than the text, are available on Library Reserve.  Most of these in turn are available electronically through ARES.  To access ARES, please go to the Library Homepage and click on ARES under POPULAR LINKS at the bottom of the page on the right-hand side.  You will need your student computing account information. 


Richard Carson, Instructor 
  B850 Loeb Building 
  (613)520-2600, x1751. 



Econ 3870V

                                                                                   FINAL EXAM

                                                  Answer Key


Note:  The answers below are longer and more thorough than we expect student answers to be.




I-1a.  We define extensive growth as growth of output or value added owing to growth of inputs, with technology held constant, and intensive growth as growth of output/value added owing to broadly-defined technological progress, with inputs held constant.  The three types of growth are then (a). extensive; (b). intensive and based on catching up technologically by importing technology already in use abroad; (c). intensive and based on domestic innovation and sharing of new technology developed abroad.

An economy passes from (a) to (b) or (c) when a major share of economic growth is accounted for by broadly-defined technological progress rather than by quantity increases in the factors of production, notably capital.  It passes from (b) to (c) as it relies more and more on domestic innovation and sharing of new technology to generate growth, rather than on technology catch-up.

Any nation may rely on extensive growth for a time, but such an economy must eventually become able to generate intensive growth, or growth will die out, owing to the inability to further increase some inputs, notably labour, and consequent diminishing returns to those inputs that can be increased, notably capital.

Such growth occurs mainly because of a rising capital-to-labour ratio—the result of high rates of (often forced) saving and investment—and for a time, rising labour force participation, falling unemployment, and migration of labour from agriculture to industry. Eventually these sources of new labour for industry are exhausted, and expansion of capital then gives rise to diminishing returns, in the form of a falling marginal product of capital and return on investment.  In the Soviet Union, the capital-to-labour ratio soared over time, while the return on investment imitated Niagara Falls.

Type (b) growth—or intensive growth based on imports of technology already in use abroad—is possible in an economy with many subsidies and controls.  These controls are used to channel resources into technology acquisition and into sectors believed to have growth potential, using the new technologies.  The technology-importing country may also implement information sharing between firms in order to disseminate these technologies more rapidly.  The process of learning to use new technologies and to make products based on them is likely to be subsidized.

The result is a strategy of import substitution, or of restricting imports of designated products and of replacing these with domestic production.  It may also be a strategy of changing the nation’s comparative advantage toward higher value-added products, whose exports are promoted.  In East Asia, the basic evolution was away from labour-intensive toward physical-capital-intensive and then knowledge- or human-capital-intensive production.  Restrictions, subsidies, and controls were needed because such a strategy meant specializing against current comparative or cost advantage.  These interventions probably increased growth for a time.

By the time the industries being promoted catch up technologically, the economic usefulness of promoting them further vanishes.  The government is then left with subsidies/controls that lower efficiency and are a threat to further growth, but which are politically difficult to remove.

Thus only type (c) growth can be sustained over the long run.


I-1b. Economic growth in Soviet-type economies was largely extensive and led to a fall of investment returns, as the above argument predicts.  Economic growth in Western countries has been largely intensive.  The main reason for this is that the Soviet-type economy suppressed innovation for the reasons outlined on pp. 57-59 of Market and State in Economic Systems. The STE also had a hard time absorbing imported technology, because of its highly bureaucratic nature—the bureaucrats couldn’t easily incorporate new products into their planning—and its lack of orientation to demand.  It frequently made bad choices about which types of technology to import.

The result was that after initial spurts of growth, the technological level of the STEs fell further and further behind that of Western and East Asian nations.


I-2.  Inequality has risen in Canada and in other Western countries since the mid-1970s. In particular, there has been a widening income gap between the earnings of unskilled and skilled labour and between the earnings of those with and without post-secondary education. At the same time, the rate of growth of labour productivity has fallen below its long-run trend.


The rise of inequality has three basic causes—rent seeking, globalization, and the technological revolution based on the micro-processor and information-based technologies:


First:  After the collapse of Soviet-style socialism, an emphasis on deregulation has enabled financial institutions to extract large amounts of wealth from the rest of the economy, while amassing political power. In the process, public sector deficits have reached record levels.  This “rent seeking,” as economists sometimes call it, has been less of a problem in Canada than in the U.S. or Europe.  Especially in the U.S., as in some developing economies, notably China, rent seeking—basically the use of resources to redistribute wealth toward particular individuals or groups—now seems to be playing a major role, first in creating inequality and then in sustaining it.


Second:  Growing economic integration (globalization) has featured falling barriers to international trade, investment, and technology transfer plus the emergence or expansion of regional trading blocs, such as NAFTA and the European Union. Workers in high-wage countries now face stiffer competition from lower-wage areas, with the resulting disappearance of good-paying jobs.


Third:  the invention of the microprocessor has given rise to explosive growth of information-based technologies, which has promoted company downsizing, automation, and the elimination of many less-skilled jobs. In the process, it has raised inequality by raising the skill premium in earnings and by generating abnormally high profits for some companies and high losses or bankruptcy for others.  New ways of transmitting information have enlarged markets for highly-skilled suppliers of services at the expense of less skilled local suppliers by enabling the former to reach larger numbers of potential customers.


An explanation of the recent rise in inequality based on the Kuznets curve would stress the third or technological explanation.  (The Kuznets curve is shown on p. 156 of Market and State in Economic Systems.)


The Kuznets Curve approach argues that modern economic growth, based on expansion of industrial output and output of services, coincides with two effects on inequality. This has been observed in many countries:


1.    At first, inequality rises with economic development based on industrial growth. In the early stages of industrial growth, inequality increases, although even the poorest groups in society often receive some benefit.


2.    Subsequently, inequality falls.  In the U.K., inequality began rising around 1760 and continued to increase for about 100 years.  It was this widening that Marx and Engels observed.



Marx and Engels explained the initial rise of inequality (which they expected to continue under capitalism) in terms of a labour-saving bias in technological change. They failed to observe the subsequent fall of inequality, beginning around 1870 in the U.K., and in the late 1920s in North America.


Greenwood's explanation attaches a Kuznets curve to each major phase of the industrial revolution. We are now in the third phase, which is based on the revolution in information technologies, after phases based on steam power and on the combination of electricity, internal combustion, and the assembly line.  Marx and Engels observed only the first, or steam phase. It plausibly accounts for the Kuznets curve observed in the U.K. and some other European nations, while the electricity/internal combustion/assembly line phase plausibly accounts for the Kuznets curve observed in North America.

The information revolution would be the major cause of widening of inequality since the mid-1970s according to this view, which holds that the widespread adoption of any new basic technology is a skill-intensive process.  Relatively highly-skilled workers learn to use the new technology more quickly and easily than less-skilled workers.  At first, therefore, the supply of people with the right skills (the "new-economy" skills) is low and inelastic. The demand for these shifts upward as a result of technological change, dramatically raising the skill premium in the earnings of people with new-economy skills.

At the same time, the old-economy skills of many workers have become obsolete. Their marginal productivities are reduced until they acquire new-economy skills. The net result is to raise inequality of earnings and to lower the growth of labour productivity.  The widespread adoption of new technologies also creates opportunities for creative destruction, thereby generating abnormal profits and losses.

However, this widening of inequality is temporary, according to the Greenwood explanation.  As the new technology comes into widespread use, the skill premium in earnings tends to fall for two reasons:


I. DEMAND SIDE:  Over time, cost conscious firms learn how to substitute away from more skilled toward less skilled labour, which is also less expensive.  This is part of learning how to make better use of the new technology.  Standardization and routinization of products and procedures are part of this substitution.



II. SUPPLY SIDE: Less-skilled workers seeking better earnings will, in time, acquire the new-economy skills demanded by the information age, both by retraining and by accumulating the right kind of job experience.  This shifts the supply curve of workers with the requisite skills to the right, and enables them to raise their productivity. 


Thus the widening of inequality goes hand-in-hand with a slowing of labour productivity growth, and the subsequent fall in inequality coincides with rising growth of labour productivity.


In addition, opportunities for creative destruction gradually dwindle, as the new technology is more widely absorbed and understood.  As a result, abnormal profits and losses resulting from the new technology decline.  Eventually, therefore, inequality is forecast to peak and then to begin falling.


However, other factors may also be involved in the Kuznets curve.  For example, the extension of voting rights in Western Europe in the 19th and early 20th centuries probably helped to reverse the previous rise of inequality there.  Moreover, the technological explanation above ignores the rent-seeking aspect of inequality, which may be having an effect more like that which Marx and Engels foresaw.


                                                                     SECTION II



II-1a. Before reform began in Nov. 1978, China was a Soviet-type economy, relying largely on extensive growth, or growth owing to increases in inputs, with little technological improvement.  This was largely industrial growth, which featured a rapid increase in capital per unit of labour in the state sector.  As a result, the return on investment fell, and total factor productivity—output per unit of combined capital and labour input—stagnated.

China’s economy became increasingly backward.  After Mao’s death, reformers were determined to change this and introduced the Open Door policy, along with limited reform of industry and relaxation of controls over agriculture, which resulted in de-collectivization and a return to farming by households and small groups. The land was divided into household plots, although government retained ownership, and peasants leased their land from the state.

The switch from collective to individual and small group farming quickly revealed that China had too little land and too many farmers.  Something had to be done to employ the peasants who were left with too little land to support themselves or with no land at all. Thus restrictions on rural industry and services were relaxed.  Collective and private firms became widespread in rural areas, and many rural dwellers were allowed to seek jobs in industry and services. 

This was the start of China’s high growth period.  Foreign investment has played a major role in financing this growth. Collective and private firms also sprouted in urban areas, and state firms carried out limited reforms, although widespread privatization of small state firms and corporatization of large ones did not occur until the mid-1990s.

Much of this growth continued to be extensive—taking advantage of the new mobility of labour out of agriculture and into industry and services—but foreign investment also brought in new technology and modern management methods.

Thus China shifted from type (a) or extensive growth to a combination of type (a) and type (b) intensive growth, based on catching up technologically by importing technology already in use abroad. Today she continues to rely on this combination.  

Chinese growth has depended on three main factors: a high rate of investment, including foreign investment, the transfer of millions of workers from farming to low-wage jobs in industry, both locally and as migrant workers, and the transfer of technology to Chinese firms (or joint ventures) from abroad.  These three factors have reinforced one another.  The accumulation of capital and the improvement of technology have raised the marginal product of labour, allowing a given level of marginal productivity to go with a much larger labour supply, thereby permitting huge increases in the amounts of labour employed, both in industry and, more recently, in services.

Growth has also been export-led, and China's cost advantage has relied on low-wage labour, an undervalued currency, and in some cases on low-cost loans and other subsidies.  Despite some success, she has found it harder than did the smaller East Asian economies and Japan to switch to relying on inexpensive human capital.  She hasn’t moved away from labour-intensive production toward human-capital or knowledge intensive production as quickly as other East Asian economies had done before.

China was well placed to embark on this growth in the early 1980s.  She had a vast reservoir of under-utilized labour, and the capital-to-labour ratio was low, except in state firms that were notoriously inefficient.  In addition, the technological level was low.


II-1B. As noted, China’s cost advantage has depended mainly on low-wage labour and an under-valued currency.  Unlike the smaller East Asian nations and Japan, China has not yet been able to rely mainly on relatively inexpensive human capital or indigenous innovation.

This implies limits to current growth, especially in light of the aging of her population. Eventually, labour will become scarce, and wages will be forced upward, eroding China’s cost advantage, a process that has already begun. Upward pressure on the renminbi is reinforcing this erosion.  And low growth of demand in China’s export markets may make the achievement of further export growth harder still.

However, the resulting need to re-orient growth toward domestic demand runs into a barrier stemming from the high rate of household saving in China. This barrier is unlikely to come down as long as the system of government pensions is underdeveloped (outside the state sector), while interest rates remain below the rate of inflation in order to subsidize the state sector, and most Chinese households have low access to credit.  In effect, this subsidy is paid for by an inflation tax on households.

As a result, a high rate of saving is needed not only for retirement, but also to pay for large purchases, such as weddings and durable goods.  At the same time, too much financial capital is tied up in the state sector and in other types of unproductive loans that do not create much growth. Chinese state banks have a high proportion of bad debt (zombie banks, in effect) because they are obliged to carry out government policies, notably support of production and employment in the state sector, where borrowers often fail to repay principal and interest on time.  In general, too many resources are allocated to activities with low efficiency, and financing these activities leads to bad debt.

Thus the savings of millions of domestic savers in China are invested in loans with a low average return.  If these savings would start to fall, owing to the aging of the population, or to greater domestic consumption by younger age groups, or for any other reason, including a run on the banks, there could be a financial crisis, since many bank loans could not be recalled.  Banks would have to be propped up by subsidies financed by higher taxes or by money supply expansion, causing inflation. Alternatively, access to bank savings could be restricted, but this would make new deposits less likely.  Still another alternative would be to close inefficient state firms and curtail inefficient investment of all kinds, but then many jobs would be lost and many influential Party members would be harmed.

A crucial requirement of type (c) growth, or growth based on domestic innovation and sharing of new technology developed abroad, is an efficient financial sector that channels savings into their most productive uses. At present, China’s banking sector fails to do this. It can succeed only when its political role is greatly reduced, along with its access to government bail-out funds—ie., the budget constraints of China’s state banks need to be hardened.  Less protection of China’s state sector from competition and greater access to credit for non-state firms are needed as well.

Type (c) growth is the only kind that can be sustained indefinitely.  For China, the easiest growth has been realized, and the road ahead will be harder and more uncertain than the road that has been travelled. This should not prevent us, however, from acknowledging what has been a truly remarkable achievement thus far.



II-1c. Before 1980, prices were controlled in China and were usually not increased in response to increases in demand.  Therefore, such increases led to repressed inflation in the form of growing shortages of many products, rather than to open inflation.  The gap between supply and demand at controlled official prices widened, as did the differences between official price and demand prices. 

In the figure below, the shortage increases from (Q1 -Q0) to (Q2 -Q0) and the gap between the demand and official prices rises from (P1-P0) to (P2 -P0) when demand shifts upward.  Part of the reason for rising demand was economic growth, but another part was increasing budget deficits owing to lack of financial discipline (the soft budget constraint).


Growing shortages were favourable to the development of black markets (the "second" or "underground" economy), although the state and Communist Party strove to suppress these.  In practice, rationing became tighter and more comprehensive, and waiting lists grew longer--both manifestations of growing shortages and rising differences between official and demand prices.  The incentive to earn money fell, and factory downtime rose, owing to shortages of inputs.   Efficiency suffered.




II-2a.  Before 1980, the renminbi was overvalued. Equivalently, the currencies of Western countries were undervalued at official exchange rates. This made Western and Asian products look inexpensive.  It created an excess demand for foreign products to match the excess demand for many domestic goods and services.

Access to imported goods was therefore subject to a rationing or quota system. An importer needed a quota to get the import, and his access to same depended on state priorities along with his own influence.  At the same time, exports were subsidized—since they would otherwise have been overpriced at official exchange rates—and imports were taxed.  Trade was at an extremely low level.


Following transition, this “closed-door” policy was reversed.  The renminbi became undervalued, in order to encourage exports.  China went from being import-oriented to being export-oriented, and growth became export-led.  A low renminbi allowed China to price her exports attractively in foreign markets.  China also went from an emphasis on self-sufficiency and very low trade to becoming the world’s leading exporter. 

More recently, the renminbi has been rising, and some empirical studies and economists suggest that its value vis-à-vis Western currencies is now about right. Yet China’s large trade surplus remains, and coincides with a chronic deficit for China’s leading trading partner, the U.S.  How can persistent surpluses for China and deficits for the U.S. co-exist if the exchange rate between the two currencies is about right?

The answer comes from a basic macro-economic accounting identity. If we break down national income or GDP into its component parts by expenditure, we have: Y = C + I + G + NE, where Y is GDP or national income, C is consumption, I is investment, G is government expenditure, and NE is net exports (or exports minus imports).  At the same time, Y is either consumed or saved or taxed away, Y = C + S + Tx.  Thus S + Tx = G + I + NE, which gives (S – I) + (Tx – G) = NE. 

This equation says that the surplus of domestic savings over investment plus the budget surplus equals the trade surplus.  A budget deficit is a negative surplus here.  It follows that a country with a huge surplus of savings over investment and a small budget deficit must have positive net exports or a trade surplus. Such a country is China.  And a country with low savings relative to investment plus a large budget deficit must have a trade deficit—such a country is the U.S.  And several European countries would also have to have trade deficits, largely because of their large budget deficits.

One cannot expect these surpluses and deficits to be removed by exchange rate adjustments. Instead they require potentially painful structural reforms, which would lower domestic savings in China by improving the system of state pensions and raising household access to credit. The U.S. would have to get its budget deficit under control and give better incentives for households and businesses to save.


II-2b. Shadow banks exist in many countries.  Generally, they arise to supply loans to would-be borrowers who can’t obtain credit from the banks.  In China, state banks, who control most of the country’s lending capacity, lend mainly to other state firms.  This leaves a vast army of non-state firms and households which are under-supplied with loans or which are not supplied at all.  Not surprisingly, therefore, China has a large sector of shadow banks.