Answers and Explanations for

selected MoE’s Model Exit

Exam Questions for the
Department of Economics
(BA)

July,2023
Message from the writer

Dear Candidates,

This document provides answers and explanations to 28 questions from

a total of 94 questions in the mock test prepared by MoE for the department of
Economics. I did not intend to publish an incomplete doucument like this when
I started working on this material. But as the work progressed, I realized that it
is a very time costly process. And as an exam candidate myself, I am rushing to
revise the courses for the exam that will be conducted in a few days time. I
would like to apologize for not being able to deliver a full length explanation.
Please reach me out through [email protected] for comments. If
there is any ammendment or correction, I will post it on the following telegram
channel. https://t.me/ethio_econ

I wish you the best of luck in the upcoming exit examination.

Eyuel
Premium College
Addis Ababa, Ethiopia
Question 1

Question Description
Theme Quantitative Methods in Economics with application
Course Name Mathematical Economics
Chapter Chapter 5: Difference Equations

Solution
In the simple multiplier analysis, a single investment expenditure in period 0
will call fourth successive rounds of spending, which in turn will bring about
varying amounts of income increment in succeeding time periods. Using y to
denote income increment, we have y0 = the amount of investment in period 0;
but the subsequent income increments will depend on the marginal propensity
to consume (MPC). If MPC = 0.75 and if the income of each period is consumed
only in the next period, then 75 percent of y0 will be consumed in period 1,
resulting in an income increment in period 1 of y1 = 0.75y0. By similar
reasoning, we can find y2 = 0.75y1, etc. By iteration we have
𝑦1 = 0.75𝑦0
𝑦2 = 0.75𝑦1 = 0.75(0.75𝑦0 ) = (0.75)2 𝑦0
𝑦3 = 0.75𝑦2 = 0.75(0.75)2 𝑦0 = (0.75)3 𝑦0
These can be summarized into the solution 𝑦𝑡 = (0.75)𝑡 𝑦0 .
Hence, the correct answer is choice (B) 𝑦𝑡 = (0.75)𝑡 𝑦0 .
Question 2

Question Description
Theme Basic Macroeconomics
Course Name International Economics II
Chapter Chapter 3: Balance of Payments

Solution
When the autarky price is below relative price of future consumption, future
consumption is relatively cheap in the home economy and present consumption
is relatively expensive. Thus, home economy will “import” present consumption
from abroad in the first period (by running a current account deficit) and
“export” future consumption later (by repaying its foreign debt). This result is
in accord with the principle of comparative advantage from international trade
theory, which states that countries tend to import those commodities whose
autarky prices are high compared with world prices and export those whose
autarky prices are comparatively low.
Hence the correct answer is (B) importing present consumption and exporting
future consumption.
Exam Tip
Note that choice (C) and (D) are the same except the word “current” is used in
place of “present” in choice (D). This rules out both choices as an answer. Hence
it is helpful to scrutinize questions in the exam even if you do not fully
comprehend what the question is really asking.
Question 3

Question Description
Theme Basic Macroeconomics
Course Name Macroeconomics I
Chapter Chapter 1: The state of Macroeconomics

Solution
Keynesian economics: the macroeconomic generalizations that lead to the
conclusion that a capitalistic economy is characterized by macroeconomic
instability and that fiscal policy and monetary policy can be used to promote
full employment, price-level stability, and economic growth.
Keynesian economists believe that the self-correcting feature of the market,
which is of course the hallmark of classical theory, does not work. They think
that prices and especially wages respond slowly to changes in supply and
demand, resulting in shortages and surpluses.
With regard to the role of the government, Keynes argued that the government
role was needed to preserve capitalism because without management, a
modern capitalist economy is so unstable that it may threaten the social
compact that it rests on.
Hence the correct answer is choice (D) Keynesian Economists believe that
general equilibrium is not attained relatively quickly because the price level
adjusts slowly (is sticky).
Question 4

Question Description
Theme Basic Macroeconomics
Course Name Development economics I
Chapter Chapter 3: Growth Models and Theories of development

Solution
The essence of structuralism is that the LDCs should focus their
development effort within themselves by mobilizing their internal potentials
and resources. Structuralism tended to blame the increasing income disparities
between the developed countries (DCs) and the Least developed countries
(LDCs) on the legitimacy accorded to the existing pattern of world economic
order by neo classical models and tenets.
Structuralist economic thinking is driven by the notions of the
peculiarities of the particular economic systems and their structural
circumstances. It is based on the notion that development must be fashioned in
accord with the economy’s particular situation: level of development at the
time, historical circumstances, geographical conditions, political setting, and
the prevailing and overall global economic environment.
Hence the correct answer is (D) Given the structural differences LDCs can not
replicate what DCs have done in the past. Thus, both LDCs and DCs cannot
follow similar growth trajectory.
Question 5

Question Description
Theme Basic Microeconomics
Course Name Microeconomics I
Chapter Chapter 3: The Theory of Production
Solution
Isoquants when inputs are perfect Fixed-proportions (Leontief)
substitutes production function

When the isoquants are straight lines, When the isoquants are L-shaped, only
the MRTS is constant. Thus the rate at one combination of labor and capital
which capital and labor can be can be used to produce a given output
substituted for each other is the same (as at point A on isoquant q1, point B
no matter what level of inputs is on isoquant q2, and point C on
being used. Points A, B, and C isoquant q3). Adding more labor
represent three different capital- alone does not increase output, nor
labor combinations that generate the does adding more capital alone.
same output q3.

Hence the correct answer is (B) there is only one efficient production process.
Question 6

Question Description
Theme Basic Microeconomics
Course Name Microeconomics I
Chapter Chapter 4: Theory of Costs

Solution
The relationship between cost and production curves can be summarized by
the diagram below.

The following important points

can be taken away from the graph.
▪ TVC and TP of labor are
inversely related.
▪ AVC and AP of labor are
inversely related.
▪ MC and MP of labor are
inversely related.

Hence the answer is (D) Average product is at its maximum.

Question 7

Question Description
Theme Basic Macroeconomics
Course Name Development economics I
Chapter Chapter 5: Income Inequality, Poverty and Development
Solution
Even though the Lorenz curves were not visible during the exam, let us use the
Lorenz curves below to study the general properties. In the “Lorenz criterion”
of income distribution, whenever one Lorenz curve lies above another Lorenz
curve, the economy corresponding to
the upper Lorenz curve is more equal
than that of the lower curve. Thus,
economy A may unambiguously be
said to be more equal than economy D.
Whenever two Lorenz curves cross,
such as curves B and C, the Lorenz
criterion states that we “need more
information” or additional
assumptions before we can determine
which of the underlying economies is
more equal.
Hence, had the question included a similar Lorenz curve, the answer would
have been (A) For every percentage of income the percentage of income
recipients in country B are greater than those in country A.
Question 8

Question Description
Theme Basic Macroeconomics
Course Name Macroeconomics I
Chapter Chapter 2: National Income Accounting
Solution
The GDP deflator and the CPI give somewhat different information about
what’s happening to the overall level of prices in the economy.
▪ The first difference is that the GDP deflator measures the prices of all
goods and services produced, whereas the CPI measures the prices of only
the goods and services bought by consumers. Thus, an increase in the price
of goods bought only by firms or the government will show up in the GDP
deflator but not in the CPI.
▪ The second difference is that the GDP deflator includes only those goods
produced domestically. Imported goods are not part of GDP and do not show
up in the GDP deflator.
▪ The third and most subtle difference results from the way the two measures
aggregate the many prices in the economy. The CPI assigns fixed weights to
the prices of different goods, whereas the GDP deflator assigns changing
weights. In other words, the CPI is computed using a fixed basket of goods,
whereas the GDP deflator allows the basket of goods to change over time as
the composition of GDP changes.
Hence the answer is (D) GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
Question 9

Question Description
Theme Basic Microeconomics
Course Name Microeconomics I
Chapter Chapter 6: Pure Monopoly Market
Solution
The general expression for
Marginal Revenue
Applying the product rule of
derivative

Substituting elasticity
Equating MR and MC
1
MC = P + P ( )
ed
1
MC = 15 + 15 (− )
5
MC = 15 − 3
MC = 12
Note that the price elasticity of demand is negative and -5 should be used
instead of 5 when substituting elasticity. In fact, you might find the above
1
formula written as MC = P − P ( ) in some books which already consider the
e d
negative slope of demand curve at the beginning of the derivation process.
Hence the answer is (B) 12.
Question 10

Question Description
Theme Quantitative Methods in Economics with application
Course Name Econometrics I
Chapter Chapter 2: Simple Linear Regression

Solution
One of the assumptions underlying the method of least squares in The classical
linear regression models is linearity in parameters, though it may or may not
be linear in the variables. Linear in parameter means the 𝛽′𝑠 (that is the
parameters) are raised to the first power only.
Hence the answer is (D) The model is linear in the intercept and slope
parameter.
Question 11

Question Description
Theme Basic Microeconomics
Course Name Microeconomics I
Chapter Chapter 1: Theory of Consumer Behavior and Demand

Solution
∂U
MU1 = = 0.4q1 −0.6 q2 0.6 (Equation 1)
∂q1
∂U
MU2 = = 0.6q1 0.4 q2 −0.4 (Equation 2)
∂q2
MU1 MU2
The utility maximized in ordinal utility approach when =
P1 P2

0.4q1 −0.6 q2 0.6 0.6q1 0.4 q2 −0.4

=
6 10
Equating the ratio of Equation (1) and (2) with respect to their prices, we get
q2 = 0.9q1 (Equation 3)
Based on the information in the question the budget line is
6q1 + 10q2 = 144 (Equation 4)
Substituting Equation (3) in Equation (4) we get q1 = 9.6 and q2 = 8.64.
Hence, the answer to the question is not provided in the choices.
Question 12

Question Description
Theme Basic Macroeconomics
Course Name International Economics II
Chapter Chapter 1: The Foreign Exchange Market

Solution
The current account-based demand for foreign currency results from the desire
to purchase goods and services from another country and to make unilateral
transfers. In a sense, the demand for foreign currency is a secondary or derived
demand because the foreign currency is a means to acquiring something else.
Hence, the answer is (B) Derived demand.
Question 13

Question Description
Theme Basic Macroeconomics
Course Name International Economics I
Chapter Chapter 5: International Trade Institutions and Regional
Economic Arrangements

Solution
The most important new aspect of the WTO is generally acknowledged to be its
“dispute settlement” procedure. A basic problem arises when one country
accuses another of violating the rules of the trading system.
A dispute can arise when one country adopts a trade policy or violates the WTO
agreements. The WTO member countries use a multilateral system of settling
disputes instead of taking actions unilaterally, meaning abiding by the agreed
WTO procedures and respecting judgments. However, the WTOs priority is to
settle disputes through consultations and not to pass a judgment.
Hence the answer is (B) unfulfilled promises with respect to one or more of the
WTO agreements.
Question 14

Question Description
Theme Quantitative Methods in Economics with application
Course Name Econometrics II
Chapter Chapter 1: Regression Analysis with Qualitative Data

Solution
There are four approaches to developing a probability model for a binary
response variable:
1. The linear probability model (LPM): is the simplest possible binary
regression model in which the binary response variable is regressed on the
relevant explanatory variables by using the standard OLS methodology.
2. The logit model: in this model the dependent variable is the log of the odds
ratio, which is a linear function of the regressors. The probability function
that underlies the logit model is the logistic distribution.
3. The probit (normit) model: emerges from normal cumulative distribution
functions (CDF). This model is mathematically a bit difficult as it involves
integrals.
4. The tobit model: is closely related to the probit model and is also known as
a censored regression model. In this model, the response variable is
observed only if a certain condition(s) is met.
Hence the answer is (A) Probit Model.
Question 15

Question Description
Theme Basic Macroeconomics
Course Name Monetary Economics
Chapter Chapter 1: Money and Monetary Theories

Solution
Fiat money, in a broad sense, all kinds of money that are made legal tender by a
government decree or fiat. The term is, however, usually reserved for legal-
tender paper money or coins that have face values far exceeding their
commodity values and are not redeemable in gold or silver.
The word “fiat” is Latin in origin and refers to an arbitrary order issued by a
government or other authoritative figure. When applied to paper money, fiat
currency refers to the scary notion that our dollar has value only because the
government says it does.
Hence the answer is (A) Backed by government.
Question 16

Question Description
Theme Basic Macroeconomics
Course Name Monetary Economics
Chapter Chapter 3: The demand for money and other assets

Solution
According to Keynes’s Liquidity Preference Theory, there are three motives
behind the demand for money.
1. Transactions Motive: individuals are assumed to hold money because it is a
medium of exchange that can be used to carry out everyday transactions.
2. Precautionary Motive: people hold money as a cushion against an
unexpected need.
3. Speculative Motive: people hold money as a store of wealth.
Hence the answer is (C) sudden technological changes.
Additional Note
Keynes’s resulting liquidity preference theory views that the transactions and
precautionary components of money demand are proportional to income.
However, the speculative component of money demand is viewed as sensitive
to interest rates as well as to the expectations about the future movements of
interest rates. This theory, then, implies that velocity is unstable and can not be
treated as a constant.
Question 17

Question Description
Theme Basic Microeconomics
Course Name Microeconomics I
Chapter Chapter 3: The Theory of Production

Solution
▪ If raising all inputs (independent variables) k-fold raises the output by
more than k-fold, it is an increasing returns to scale.
▪ If raising all inputs (independent variables) k-fold raises the output
exactly k-fold also, it is a constant returns to scale.
▪ If raising all inputs (independent variables) k-fold raises the output by
less than k-fold, it is a decreasing returns to scale.
For the given homogeneous production function Y = AK 0.9 L0.5 , if all inputs are
increased β times,
Y(βK, βL) = A(βK)0.9 (βL)0.5
Y(βK, βL) = β0.9+0.5 AK 0.9 L0.5
Y(βK, βL) = β1.4 AK 0.9 L0.5
Hence, the answer is (C) β1.4 times and therefore the returns to scale is
increasing.
Question 18

Question Description
Theme Quantitative Methods in Economics with application
Course Name Econometrics I
Chapter Chapter 3: Multiple Linear Regression
Solution
When elements in the principal diagonal of (X T X)−1 are multiplied by the
regression variance, they give the regression parameters.
𝟐 3.5 −1
T −1
(X X) = [3.5 𝟏 6.5]
−1 6.5 𝟒
Var (β̂1 ) = 0.91 × 2 = 1.82

Var (β̂2 ) = 0.91 × 1 = 0.91

Var (β̂3 ) = 0.91 × 4 = 3.64

Hence, although choice (C) is the closest to the actual value, the exact answer to
the question is not provided in the choices.
Additional information
The parameters could also be estimated from the matrix by multiplication.
β̂1 2 3.5 −1 −3 1.1
T −1 T ̂
β = (X X) (X Y) = [β2 ] = [3.5 1 6.5] [2.2] = [−4.4]
β̂3 −1 6.5 4 0.6 19.7

Hence the demand model can be written as yt = 1.1 − 4.4X2 + 19.7X3

Interpretation: A 1 unit increase in own price of the commodity, decreases the
quantity demanded of the commodity by 4.4 units on average holding the
income of the individual constant.
A 1 unit increase in the income of individual by 1 unit, increases the quantity
demanded of the commodity by 19.7 units on average holding own price of the
commodity constant.
Exam Tip
Do not be scared off by seemingly complicated questions. As you saw in the
question above, some questions might only require a simple multiplication to
arrive at the answer even though too much information is given to distract
candidates.
Question 19

Question Description
Theme Basic Microeconomics
Course Name Microeconomics II
Chapter Chapter 1: Monopolistic Competition

Solution
Although the demand curve is missing in the exam question, let us try to study
how a similar question would have been approached. Shown below are the
curves for a monopolistically competitive firm in the short and long run.
Short Run Long Run

As it can be seen in the curves above, monopolistically competitive firms earn

zero profit (normal profit) in the long run. Hence all we need to do is equate the
LAC and DLR to determine the long run equilibrium price and output.
Suppose the long run derived demand curve is P = 44 − 4q and the long run
average total cost curve is LAC(q) = q2 − 20q + 108 for a firm in monopolistic
competition, the long run equilibrium price and output can be calculated as
follows.
In the long run,
LAC = P
q2 − 20q + 108 = 44 − 4q
q2 − 16q + 64 = 0
(q − 8)2 = 0
q=8
Substituting the quantity in the demand curve yields
P = 44 − 4(8) = 12
Hence, the long run equilibrium price and output respectively is 12 and 8.
Additional Note
▪ Monopolistic competition is a market structure in which large number of
firms compete by selling differentiated products.
▪ The demand curve of a firm under monopolistic competition is flatter or
more price-elastic than that of a monopolistic firm.
▪ In the short run, monopolistic competition firms act as a monopolist and
optimal decision by equating marginal revenue with marginal cost.
▪ Monopolistic competition firm in the long run make output decision at
higher cost. It is produced at a point before the minimum long run average
cost. As a result, firms in monopolistic competition industry said to be
inefficient. They could not use the full capacity.
Question 20

Question Description
Theme Basic Microeconomics
Course Name Development Planning and Project Analysis II
Chapter Chapter 2: Financial Analysis and Appraisal of Projects

Solution
Time Cash Flow Cumulative Sum
Year 1 Birr 8,000
Year 2 Birr 15,000 Birr 23,000
Year 3 Birr 22,000 Birr 45,000
Year 4 Birr 20,000 Birr 65,000
Year 5 Birr 20,000 Birr 85,000

At the end of the 3rd year birr 45,000 out of the 60,000 initial investment has
been returned. The remaining 15,000 birr will be returned in the fourth year
15,000
where the cash flow is 20,000. Therefore, it takes = 0.75 year (9 months)
20,000
to completely pay back the remaining amount.
Hence the answer is (D) 3.75 years.
Question 21

Question Description
Theme Basic Macroeconomics
Course Name Development economics II
Chapter Chapter 3: Rural-urban interaction, migration and
unemployment

Solution
According to the Harris-Todaro Migration model
▪ Migration is stimulated primarily by rational economic considerations of
relative benefits and costs, mostly financial but also psychological.
▪ The decision to migrate depends on expected rather than actual urban rural
real-wage differentials where the expected differential is determined.
▪ The probability of obtaining an urban job is directly related to the urban
employment rate and thus inversely related to the urban unemployment
rate.
▪ Urban wages are institutionally determined (inflexible downward) as
assumed by Todaro
▪ If rural workers were free to migrate, then despite the availability of only a
few jobs, they are willing to take their chances in the urban job lottery.
Hence the answer is (B) The decision to migrate also depends on political and
social factors that can not be quantified.
Question 25

Question Description
Theme Quantitative Methods in Economics with application
Course Name Mathematical Economics
Chapter Chapter 6: Dynamic Optimization

Solution
H = 3y − u + λ(y + u)
H = 3y − u + λy + λu
H = (3 + λ)y + (λ − 1)u
The Hamiltonian function above is linear in u. If we plot H against u in the uH
∂H
plane, we get a straight line with slope = λ − 1.
∂u

The costate equation is

∂H
λ′ = − = −3 − λ
∂y
The above equation can be rewritten as 𝜆′ + 𝜆 = −3

Note
dy
For a nonhomogeneous linear differential equation + ay = b, the general
dt
b
solution is given by y(t) = Ae−at + (a ≠ 0)
a
Based on the formula provided above, the general solution to λ′ + λ = −3 is
λ(t) = Ae−t − 3
Where A is an arbitrary constant. Using the transversality condition λ(2) = 0,
we can calculate A.
0 = Ae−2 − 3
A = 3e2
Thus, the definite solution for λ is
λ(t) = 3e2−t − 3
Hence the answer is (D) λ − 1, where λ = 3e2−t − 3
Exam Tip
If you have a basic knowledge of partial differential, you can differentiate the
function with respect to u and get λ − 1 even if you do not have the concept of
Optimal Control Theory. This leaves only choice (B) and (D) as an answer and
increases your probability of selecting the correct choice. Therefore, do not
hesitate to give some complex questions a try if you have extra time left after
attempting the questions you can confidently answer.
Question 26

Question Description
Theme Basic Macroeconomics
Course Name Monetary Economics
Chapter Chapter 4: The Money Supply Process

Solution
The multiple increase in deposits generated from an increase in the banking
systems reserves is called the simple deposit multiplier. The formula for the
multiple expansion of deposits can be written as follows:
1
∆D = × ∆R
r
where
▪ ∆D is the change in total checkable deposits in the banking system.
▪ r is the required reserve ratio.
▪ ∆R is the change in reserves for the banking system.
100
∆𝐷 = = 1000
0.1
Hence the answer is (C) 1,000 Birr.
Question 90

Question Description
Theme Basic Macroeconomics
Course Name International Economics I
Chapter Chapter 3:
Solution
The most important type of trade restriction has historically been the tariff. A
tariff is a tax or duty levied on the traded commodity as it crosses a national
boundary.
Tariffs can be ad valorem, specific, or compound.
▪ The ad valorem tariff is expressed as a fixed percentage of the value of the
traded commodity.
▪ The specific tariff is expressed as a fixed sum per physical unit of the
traded commodity.
▪ A compound tariff is a combination of an ad valorem and a specific tariff.
For example, a 10 percent ad valorem tariff on bicycles would result in the
payment to customs officials of the sum of $10 on each $100 imported bicycle
and the sum of $20 on each $200 imported bicycle. On the other hand, a specific
tariff of $10 on imported bicycles means that customs officials collect the fixed
sum of $10 on each imported bicycle regardless of its price. Finally, a compound
duty of 5 percent ad valorem and a specific duty of $10 on imported bicycles
would result in the collection by customs officials of the sum of $15 on each
$100 bicycle and $20 on each $200 imported bicycle.
Hence the answer is (D) fixed percentage of the value of the traded commodity.
Question 91

Question Description
Theme Basic Microeconomics
Course Name Development Planning and Project Analysis II
Chapter Chapter 1: Basic Concepts
Solution
Project cycle involves the following stages.
1. Project Identification (Opportunity Stage)
1.1. Project Concept Definition Phase
1.2. Project Identification (Investigation) Phase
2. Project Preparation and Analysis Stage
2.1. Pre-Feasibility Study (Preliminary Screening) Phase
2.2. Feasibility Study Phase
3. Project Appraisal Stage
4. Project Implementation Stage
4.1. Pre-Investment Phase
4.2. Investment Phase
4.3. Operational Phase
4.3.1. Commissioning and starting of commercial production
4.3.2. Ex-post project evaluation
4.3.3. Replacements/Rehabilitation
4.3.4. Expansion/Innovation
5. Evaluation and Supervision
The best answer is (B) Identification →Pre-Feasibility→Feasibility →Selection
Implementation →Ex-post evaluation
Question 92

Question Description
Theme Basic Macroeconomics
Course Name Macroeconomics I
Chapter Chapter 3: Aggregate demand in a closed economy
Solution
The money market equilibrium can be depicted by the graph below.

With P and Y given and a real money supply of Ms/P, money market equilibrium
is at point 1. At this point aggregate real money demand and the real money
supply are equal and the equilibrium interest rate is R1.
Hence the answer is (B) aggregate supply of money is equal to the aggregate
demand for money,
Question 93

Question Description
Theme Quantitative Methods in Economics with application
Course Name Mathematical Economics
Chapter Chapter 6: Dynamic Optimization

Solution
The equations were not legible on the exam. The latex equations embedded in
the text has been converted to an image and rewritten as follows.
Which one of the following time paths of profit Π(t) can be derived from the
dΠ
differential equation relating profit Π, time rate of output and time t as 4tΠ =
dt
4t;
Yet, there still seems to be a type error in this question. The proper differential
equation the question intended to use isn’t clear. But here are the formulas that
could have been used to solve the question.

Note
dy
For a homogeneous linear differential equation + ay = 0, the general solution
dt
is given by y(t) = Ae−at
dy
For a nonhomogeneous linear differential equation + ay = b, the general
dt
b
solution is given by y(t) = Ae−at + (a ≠ 0)
a
Question 94

Question Description
Theme Basic Macroeconomics
Course Name Development economics II
Chapter Chapter 3: Human Capital: Education and Health in
Economic Development
Solution
The analysis of investments in health and education is unified in the
human capital approach. Human capital is the term economists often use for
education, health, and other human capacities that can raise productivity when
increased. An analogy is made to conventional investments in physical capital:
After an initial investment is made, a stream of higher future income can be
generated from both expansion of education and improvements in health. As a
result, a rate of return can be deduced and compared with returns to other
investments. This is done by estimating the present discounted value of the
increased income stream made possible by these investments and then
comparing it with their direct and indirect costs. Of course, health and
education also contribute directly to well-being.
Figure showing the Financial Trade-offs in the Decision to continue in school
It is assumed that the individual works from the time he or she finishes school
until he or she is unable to work, retires, or dies. This is taken to be 66 years.
Two earnings profiles are presented—for workers with primary school but no
secondary education and for those with a full secondary (but no higher)
education. Primary graduates are assumed to begin work at age 13, secondary
graduates at age 17. For an individual in a developing country deciding whether
to go on from primary to secondary education, four years of income are forgone.
This is the indirect cost, as labeled in the diagram. The child may work part time,
a possibility ignored here for simplicity, but if so, only part of the indirect-cost
area applies. There is also a direct cost, such as fees, school uniforms, books,
and other expenditures that would not have been made if the individual had left
school at the end of the primary grades. Over the rest of the person’s life, he or
she makes more money each year than would have been earned with only a
primary education. This differential is labeled “Benefits” in the diagram. Before
comparing costs with benefits, note that a dollar today is worth more to an
individual than a dollar in the future, so those future income gains must be
discounted accordingly, as is done in the Equation given in the question. The
rate of return will be higher whenever the discount rate is lower, the direct or
indirect costs are lower, or the benefits are higher.
This analysis was performed from the individual’s point of view in the
three right-hand columns of the table above. Notice that in sub-Saharan Africa
and Asia, the private rate of return to primary education is about 40%! Despite
this extraordinary return, many families do not make this investment because
they have no ability to borrow even the meager amount of money that a working
child can bring into the family. Note that the higher rates of return for
developing countries reflect that the income differential between those with
more and less schooling is greater on average than for the developed countries.
The first three columns of the table above indicate the social rate of
return. This is found by including the amount of public subsidy for the
individual’s education as part of the direct costs, because this is part of the
investment from the social point of view. It should be noted that these social
returns are probably understated because they do not take into account the
externality that educated people confer on others (e.g., being able to read for
other family members), not to mention other individual and social benefits such
as increased autonomy and civic participation.
Hence the correct answer is (A) The rate of return in education will be higher
whenever the discount rate is lower, the direct or indirect costs are lower, or the
benefits are higher.