metadata: authors: 0: author: Battaile,William G.
1: author: Chisik,Richard Asher
2: author: Onder,Harun
count: World
docna: 0: docna: Services, inequality, and the dutch disease
docty: Policy Research Working Paper
subtopic: Construction Industry,Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,Labor Markets,International Trade and Trade Rules,Economic Development,Business Cycles and Stabilization Policies,Inequality
teratopic: Macroeconomics and Economic Growth,Energy,International Economics and Trade,Industry,Water Resources
abstracts: cdata!: This paper shows how Dutch disease
            effects may arise solely from a shift in demand following a
            natural resource discovery. The natural resource wealth
            increases the demand for non-tradable luxury services due to
            non-homothetic preferences. Labor that could be used to
            develop other non-resource tradable sectors is pulled into
            these service sectors. As a result, manufactures and other
            tradable goods are more likely to be imported, and learning
            and productivity improvements accrue to the foreign
            exporters. However, once the natural resources diminish,
            there is less income to purchase the services and
            non-resource tradable goods. Thus, the temporary gain in
            purchasing power translates into long-term stagnation. As
            opposed to conventional models where income distribution has
            no effect on economic outcomes, an unequal distribution of
            the rents from resource wealth further intensifies the Dutch
            disease dynamics within this framework.
repnme: repnme: Services, inequality, and the dutch disease
display_title: Services, inequality, and the dutch disease
listing_relative_url: /research/2014/07/19760476/services-inequality-dutch-disease
topicv3: Manufacturing Sectors m1326521 1281,Poverty m1326687 695,Trade m1326924 698,Labor Productivity m1504060 2756,Dutch Disease m1583679 4708
publishtoextweb_dt: 2014-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Energy,International Economics and Trade,Industry,Water Resources
no_of_pages: 22
author_keys: 0: author_key: 99696
1: author_key: 1302459
2: author_key: 1127106
model_extractions: WPS6966 Policy Research Working Paper 6966 Services, Inequality, and the Dutch Disease _Bill Battaile Richard Chisik Harun Onder_ Poverty Reduction and Economic Management Network Economic Policy and Debt Unit July 2014
Policy Research Working Paper 6966

# **Abstract**

This paper shows how Dutch disease effects may arise solely from a shift in demand following a natural resource discovery. The natural resource wealth increases the demand for non-tradable luxury services due to non-homothetic preferences. Labor that could be used to develop other non-resource tradable sectors is pulled into these service sectors. As a result, manufactures and other tradable goods are more likely to be imported, and learning and productivity improvements accrue to the foreign exporters. However, once the natural resources diminish, there is less income to purchase the services and non-resource tradable goods. Thus, the temporary gain in purchasing power translates into long-term stagnation. As opposed to conventional models where income distribution has no effect on economic outcomes, an unequal distribution of the rents from resource wealth further intensifies the Dutch disease dynamics within this framework.

This paper is a product of the Economic Policy and Debt Unit, Poverty Reduction and Economic Management Network. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank. org. The authors may be contacted at Bbattaile@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Services, Inequality, and the Dutch Disease<sup>_∗_</sup>

Bill Battaile<sup>†</sup> , Richard Chisik<sup>‡</sup> , Harun Onder<sup>§</sup>

## **JELClassification:** F11, D31, Q33, Q31

**Keywords:** Resource-rich, Services, Inequality, Dutch Disease

> _∗_ We would like to thank Chad P. Bown, Leonardo Hernandez, Sudharshan Gooptu, Ahmad Ahsan and seminar participants at the World Bank for useful comments and suggestions.

> †The World Bank, 1818 H Street NW, Washington, DC 20433, Mail-Stop: H 4-402. E-mail: bbattaile@worldbank.org. Phone: +1-202-473-1714.

> ‡Corresponding author, Department of Economics, JOR-211, Ryerson University, Toronto, ON, M5B 2K3. E-mail: rchisik@arts.ryerson.edu. Phone: +1-416-979-5000 Ext. 4620.

> §The World Bank, 1818 H Street NW, Washington, DC 20433, Mail-Stop: H 4-402. E-mail: honder@worldbank.org. Phone: +1-202-473-5196.
# **1 Introduction**

The Dutch disease is an old, well-known, and still relevant paradox in economics. It describes how the initial good fortune of an exhaustible natural resource find (or a commodity price boom, or a foreign transfer, or remittances) can turn sour in the long run. It has historically been considered an exchange rate phenomenon: world demand for a newly discovered natural resource inflates the discovering country’s currency and inhibits development of the non-resource traded sectors.

Although the original use of the term Dutch disease (in the Economist magazine, 1977) referred to an appreciation of the Dutch Guilder after oil was found in the North Sea, there are several ways in which the disease can occur. In fact, although many countries lucky enough to be abundant in a valuable natural resource do suffer lower long-run growth,<sup>1</sup> it is not always clear that it is the result of an inflated currency. Historic mining towns provide a good example of the natural resource curse occurring without a concurrent currency appreciation. For example, many attractive ski towns in the western United States (from Aspen to Telluride in Colorado) were built during gold and silver booms in the mid-nineteenth century. These towns shared the same currency as the rest of the United States. Still, when the ore was depleted the towns found themselves without any other viable sources of income until the discovery of white gold (snow and lift serviced skiing) in the second half of the twentieth century. An older example is given by Potosí, Bolivia, which was famous as one of the richest cities in the world during its silver boom – that began in the sixteenth century – and has remained mired in poverty since the abundant silver stock was mostly depleted in the eighteenth century.

Recognizing the limitation of a pure exchange-rate explanation of the Dutch disease, several economists have developed models that provide additional non-monetary explanations of the natural-resource curse. Starting with Corden and Neary (1982) economists have recognized a factor of production movement effect and a spending effect as elements of the Dutch disease. In their seminal model the energy and manufactured sectors are tradable and services are non-tradable. The increased value of factors of production in the energy sector causes their movement to that

> 1Sachs and Warner (2001) note that “there is virtually no overlap in the set of countries that have large natural resource endowments – and the set of countries that have high levels of GDP”. On the other hand, Lederman and Maloney (2008) highlight the difficulty of identifying a causal relationship between natural resource finds and economic growth.

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sector and raises their nominal return which makes manufacturing more costly. Furthermore, the additional wealth from the commodity boom generates greater expenditures on services which can increase the real exchange rate. Both of these effects can generate increased reliance on imports of manufactured goods and a reduction in their production.

In Matsuyama (1992), increased labor demand by the suddenly more productive agricultural sector (which can be reinterpreted as any natural resource) and the resulting wage increase diminishes labor demand in the manufacturing sector. When the new source of wealth is exhausted, the lack of home-country learning-by-doing in these industries renders their production lost forever and the resulting long-run home-country relative wage and welfare are lower than they would have been in the absence of the resource find.<sup>2</sup> In Krugman (1987) the resource find generates increased expenditures on non-tradable goods which raises the home-country relative wage and, thereby, induces a loss of comparative advantage in some industries. Again the reduction of learning-by-doing in the now smaller manufacturing sector renders it less competitive, so that a short-run gain can generate long-run stagnation.<sup>3</sup> In this paper we address three stylized facts about the Dutch disease that are not well accounted for in these previous papers. First, many countries do not suffer a large shift of labor towards the resource sector. As noted by Brahmbhatt et al (2010) this effect is less prevalent in low-income countries. Furthermore, in many of the wealthy gulf oil states in the Middle East, the workers are brought in from abroad. As shown by Kapiszewski (2006) the percentage of foreign-born workers in Kuwait, Qatar and the UAE (in 2004) is 64.4, 70, and 81 percent of the total population. A similar example is given by many South American countries where mining constitutes a large part of export revenues, but employs a very small part of the population. For example, mining made up 59 percent of Peru’s exports in 2011 but employed only 1 percent of the labor force (Calfucura et al, 2013). Second, in countries with a large informal sector it is hard to see any evidence of wage appreciation. The informal sector is estimated to comprise 50 to 75 percent of the labor force in Latin America and Africa (Calfucura et al, 2013, document that it is 60 percent in Peru). Third, the

> 2 Matsuyama (1992) not only provides an explanation of the Dutch disease, but, more importantly, shows how an increase in agricultural productivity can generate long-run growth in a closed but not an open economy.

> 3The basic premise of production factors shifting to the sector with increased productivity follows from standard textbook models of comparative advantage (Ricardo, Ricardo-Viner, and the Rybczynski effect) and by itself, without a consequent loss of learning-by-doing or external economies of scale, would not generate lower long-run growth.

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disease does not occur in all countries that have a natural resource boom.<sup>4</sup> In this paper we address the Dutch disease, as arising solely from a shift in demand. In particular, the new found wealth from the resource find increases demand for non-tradable luxury consumption services.<sup>5</sup> Labor that could be used to develop the manufacturing sector is pulled into the service sector. Manufactured goods are more likely to be imported and the learning and production process improvements accrue to the foreign exporters. Although the newly resource abundant country may develop increased expertise in providing these services, most of these services are targeted to domestic consumption and not easily exportable, and after the resource is diminished there is less income to purchase these services. In the end the resource find can generate economic stagnation.

The key to our framework is demand shifting to these luxury services as a result of the new found resource wealth. It is common in economic models to assume that the marginal (and average) propensity to consume a good are not dependent on income. These constant income shares, that result from the assumption of homothetic preferences, are standard in the economics literature. Although they have several nice mathematical properties and are much easier to work with in formulating models, they have two very important limitations. First, they are repeatedly contradicted by the empirical evidence. From Stone’s (1954) seminal work on expenditures through Hunter and Markusen’s (1988) groundbreaking work that demonstrates its importance in explaining the pattern of trade, the data continually confirm that preferences are non-homothetic and consumption bundles do change with income. Second, aggregate demand is not affected by income distribution under the assumption of homothetic preferences. As the distribution of natural resource wealth is often unequal it is necessary to consider how changes in the distribution of this wealth affects the prevalence of the Dutch disease. In our framework we consider not only per

> 4In addition to the well-known case of Norway, Lederman and Maloney (2008) cite literature showing that Australia, Canada, Finland, Sweden, and Chile are all net natural resource exporters with no obvious indications of Dutch disease. 5We use the term "luxury" to indicate an income elasticity greater than one. Thus "luxury services" pertain to services with demand that increases with income, such as housekeeping, hiring a nanny, yard maintenance and in part retail shopping. The association of increases of these types of services with resource dependence is consistent with empirical evidence of the structural transformation of non-renewable resource economies over time. Battaile and Mishra (forthcoming) show that these types of economies on average have demonstrated a large jump in the share of GDP coming from service sectors (from 26 percent in the 1980s to 44 percent in the 2000s). This 18 percentage point shift compares to 10 and 12 percentage point gains in the share of services in GDP for low and middle income countries, respectively. In addition, resource dependent economies have had generally lower levels of trade in services, relative to other countries at similar income levels.

4
capita income but also changes in the distribution of income.

Our main result is that the Dutch disease is more likely to arise when resource rent distribution is less equal. This result is intuitive. A natural resource find is like finding money. By itself, it should not generate lower long-run welfare unless it creates expenditure distortions. If the resource wealth is narrowly distributed, then, as will be shown below the distortions are greater. Hence, given two countries with identical technologies, labor supplies, skill development, and natural resources, but differences in income distribution (solely as a result of ownership of the rents generated by the resources) the country with the less equal distribution will have less production of manufacturing goods and less development of learning-by-doing in this sector.<sup>6</sup> A second important result of our paper is that the Dutch disease can occur without any movement of productive factors to the resource sector. This result is by design of the model. In particular, the natural resource sector is modeled in such a manner that it cannot hire factors from the rest of the economy.<sup>7</sup> Hence, we can see the paradox of plenty occurring only from the shift in demand that accompanies the new found wealth. A third important result of our model is that the wage in the country that has the resource boom (or the less equal income distribution) does not increase relative to that of the other country. In fact, it can decline over time. This result occurs mainly because international trade equalizes the domestic and foreign prices of manufactures, so that relative wages are given by productivity differences across countries. When the foreign production of manufacturing is increased by the home resource find, learning by doing generates long term productivity gains and real wage appreciation in the foreign country. Therefore, unlike traditional Dutch disease models, the manufacturing sectors does not need to be more costly production in the resource abundant country. It is simply not a priority in the short run.

In the next section we describe the economy of each country. We then consider trade when resource wealth is equally distributed. Our main results occur in the second part of this third section when the resource rents are unequally distributed in one country. Our conclusions are in the fourth section.

> 6In Corden’s (1984) survey he suggests (in footnote 5) that changes in factor prices could actually overturn the spending effect found in Corden and Neary (1982). His suggestion is very different from our result which shows how the spending effect can be magnified (and not overturned) if the distribution of the resource rents is less equal.

> 7We are not the first to consider the natural resource sector as an endowment. See, for example van der Ploeg and Venables (2013).

5
# **2 Economic Environment**

To establish our main points we develop as simple model that captures our main points. Following Corden and Neary’s (1982) seminal work there are two tradable sectors in each country – natural resources (which they call energy and we will call oil) and manufacturing goods – and a nontradable luxury consumption services sector (which we call services).<sup>8</sup> The manufacturing goods include manufacturing services as well as sales and infrastructure services. There is learning-bydoing in the manufacturing sector so that increased output in the current period increases labor productivity in later periods. Items in the services sector are not tradable and include construction, entertainment, and maintenance of imported Mercedes-Benz automobiles. Manufacturing and services are produced with a constant returns to scale technology using labor, the only factor of production. Each agent is endowed with the same amount of labor and the size of the identical labor force in each country is normalized to one. In addition to their labor endowment agents may also be endowed with oil. Oil can be consumed domestically or exported. In this simple model oil is not produced with labor but is realized as an endowment. By treating oil as an endowment we can demonstrate the Dutch disease without a resource movement effect. The price of oil is set on world markets and is normalized to unity.

Formally, one unit of labor produces _Mt_ , ( _Mt_<sup>_∗_) units of the manufacturing good in the home and</sup> foreign country. Similarly, _A_ = _A_<sup>_∗_</sup> are the identical labor productivities in the services sectors in both countries. The labor productivity in manufacturing is a function of the entire past output. In particular, the labor productivity at time _t_ increases with past output as a result of the learning and refinement of the production process in previous periods. Formally, the output of manufactured goods in the home country at time _t_ is where _δ <_ 1 and _lt_ is the quantity of labor supplied to the manufacturing sector in period _t_ . Foreign learning obeys the same process with the same _δ_ . Of course, _l_<sup>_∗_</sup> _t_<sup>and</sup><sup>_Q∗_</sup> _Mt_<sup>may differ.From</sup>

> 8As Brahmbhatt et al (2010) point out “researchers typically model the economy as consisting of three sectors: the natural resource sector, the non-resource tradables sector (usually understood as agriculture and manufacturing), and the nontradables sector (including nontradable services and construction), as presented in Corden and Neary (1982).”

6
this point on we will not separately describe the foreign variables when the distinction is obvious. . The instantaneous rate of change in labor productivity in the manufacturing sector is _Mτ_ = _δQMτ_ . At times we will be interested in describing the labor productivity at time 0 before any learning has occurred ( _M_ 0). In addition we will suppress the time subscript when it is not necessary for the exposition.

Agents earn income from their labor and oil endowments. Each agent in the home and foreign countries has the same identical labor supply. There is a unit mass of agents in each country and the unit supply of labor in each country earns a wage _w_ ( _w_<sup>_∗_</sup> ). The oil endowment in each country is given as _θ_ ( _θ_<sup>_∗_</sup> ). In the foreign country each agent is endowed with the same amount of oil. The measure of home country agents who are endowed with oil is _κ_ , where 0 _< κ ≤_ 1 . We will refer to the _κ_ agents as rich and to the _1−κ_ as poor. Each of the rich agents owns _θ_<sup>_R_</sup> units of oil and _κθ_<sup>_R_</sup> = _θ_ . Hence, if _κ <_ 1,then each of the rich agents owns more than the average so that _θ_<sup>_R_</sup> _> θ_ . The measure of rich agents indexes the natural resource (and income) distribution in the home country. Inequality is decreasing in _κ_ and the distribution is equal when _κ_ approaches one. We will refer to decreases (increases) in _κ_ as a worsening (improvement) of the income distribution.

Preferences in home and foreign over the three goods are of the same Stone-Geary variety.

where _dj_ is the consumption of good _j_ and _γ >_ 0 are the amount of services that can be enjoyed without being purchased in the market. These services may consist of socializing with friends or family, playing sports, reading, or taking walks.<sup>9</sup> If _γ_ = 0, then these preferences would be CobbDouglass and agents would spend a constant income share ( _α_ , _β_ , 1 _− α − β_ ) on each of the goods. As will be seen below, with _γ >_ 0 services become a luxury good so that the marginal propensity to consume services is increasing in income. Stone-Geary preferences are more commonly depicted with _γ <_ 0 so that it determines a subsistence level of the good. This more common depiction does not allow for a consideration of income distribution because all agents must achieve the subsis-

> 9It has been suggested that these free services may also consist of publicly provided goods such as parks or city beautification. Although we like this interpretation we are wary of including it because there is no government sector or taxation in our model. In addition, as Corden (1984) suggested the Netherlands example of the Dutch disease may have been caused by the government spending the windfall on Dutch social services.

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tence level of the good and, therefore, purchase all three goods. Our luxury good version, with _γ >_ 0 allows some agents to purchase no services in the market and allows us to make meaningful statements about income distribution.

Maximization of the above utility function subject to the income constraint _PSdS_ + _PMdM_ + _dO_ = _I_ , where _Pj_ is the price of good _j_ and _I_ is income, yields the following demand functions.

The foreign country demand functions are similar. The income, I, consists of wages and oil endowment. When the oil endowment is equally distributed, we can treat the individual demand functions as the aggregate demand with income _I_<sup>_E_</sup> = _w_ + _`_ . When it is not equally distributed, the income for the rich agents is _I_<sup>_R_</sup> = _w_ + _κθ_<sup>_R_</sup> and for the poor agents is _I_<sup>_P_</sup> = _w_ . In the foreign country, where the oil endowment is equally distributed, _I_<sup>_E∗_</sup> = _w_<sup>_∗_</sup> + _`_<sup>_∗_</sup> . In order to consider income distribution we assume that only rich people can purchase services. From equation (3) this restriction on the parameters implies that Hence, when income distribution is equal there is positive demand for services by all agents. Equation (4) will be rewritten in terms of the primitives after _w_ and _PS_ are derived in equation (6) below. Inspection of equation (3) also reveals that rich home country agents also consume differing amounts of manufactured goods and oil. Although less people purchase services in the home country, (when income is not equally distributed) they purchase relatively more of them (as a result of the positive income effect given by the non-homotheticity of preferences). An important determinant of our results is that the larger purchases dominates the fewer purchasers so that 8
total purchases of services are larger when income is less equally distributed. In particular, the difference between the aggregate purchases of services by rich people when income is unequally distributed and when income is equally distributed is The above difference is strictly positive because of the restriction given in equation (4). This difference is decreasing in the measure of rich people and is, therefore, largest when income distribution is less equal (when _κ_ approaches zero).<sup>10</sup> In particular, as the measure of rich agents drops and the total oil endowment remains the same, then each of them owns more of the oil. A similar comparison shows that the aggregate consumption of manufactured goods in the equal society is greater than that in the unequal one and that this difference is also increasing in the measure of poor people It will be seen below that these differences play an important part in explaining the pattern of trade and learning-by-doing in otherwise similar economies.

# **3 International trade**

We now consider international trade between the home and foreign countries. The price of the non-traded services can differ across countries, but the price of the traded manufactured goods are the same in both countries.<sup>11</sup> Given the above described technologies we have the following four prices

> 10 Markusen (2013) makes use of a similar utility function with two goods and also shows that increased income inequality can increase demand for the luxury good. He uses this result to provide a possible explanation for the home bias effect in trade.

> 11If services were tradable, then our model would change in several ways. First, if there were zero transport cost, then our model would be Ricardian and the choice of manufacturing or services would be given by comparative advantage. Demand considerations and income distribution would only matter if they forced one country to not fully specialize. In this way, they are similar to the effects of country size on specialization and gains from trade in the standard Ricardian model with identical homothetic preferences. Allowing for a positive but non-prohibitive transport cost would not change the result but would reduce the gains from trade and allowing for prohibitive transport costs would return us to the present model.

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Using equation (6) we can rewrite equation (4) in terms of the primitives. We will refer to the restriction given in equation (7) below as assumption (1).

## **Assumption 1:**

This assumption clearly requires non-homotheticity of preferences ( _γ >_ 0). As long as the oil endowment is sufficiently large, it is more likely to be satisfied if services are more of a luxury good (larger _γ_ ), if they comprise a smaller share of total expenditure (smaller _α_ ) or if labor productivity in services (A) is not too large.

Oil can be traded, but is not produced, therefore, the total world demand must equal the total world endowment. The demand for the non-traded services must equal its supply in each country. The labor and all goods and services markets equilibrium is given by these equilibrium conditions.

# **3.1 Equal income distribution in both countries**

We start by considering international trade when both countries have the same equal income distribution. From the equality of world demand and supply for oil and the pricing equation for services we have Combining the separate zero excess demand conditions for services in each country along with the pricing equation for services yields the following two wage equations for home and foreign.

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Combining equations (9) and (10) along with the pricing equation for manufactured goods given in equation (6) completely describes the international trading equilibrium. The price of the manufacturing good and the measure of labor in the manufacturing sector in each country is then given by We can now state our first proposition.

**Proposition 1.** _Assume that oil endowments are equally distributed within each country. (i) If oil endowments are the same in both countries, then the country with greater labor productivity in manufacturing at time 0 will have a comparative advantage in manufacturing. (ii) If manufacturing technology is the same in both countries, then the country with the smaller oil endowment will have a comparative advantage in_ _<u>Mt θ α</u>_ 1 _−α−β Mt_<sup>_∗_</sup> _<u>θ</u>_<sup>_∗_</sup> _<u>α</u>_ 1 _−α−β manufactured goods. (iii) If Mt_ + _Mt_<sup>_<u>∗</u>>_</sup> _θ_ + _θ_<sup>_<u>∗</u>_</sup> 1 _−α α_ + _β and Mt_ + _Mt_<sup>_<u>∗</u>>_</sup> _θ_ + _θ_<sup>_<u>∗</u>_</sup> 1 _−α α_ + _β_<sup>_, then both countries_</sup> _produce manufactured goods. (iv) If the condition in part (iii) holds, then an increase in the oil endowment of the home country will increase the manufacturing production in the foreign country and decrease it in the home country._

_Proof._ Substituting _PM_ into the manufacturing labor supply equations and taking the ratio yields Taking the partial derivative of the above equation with respect to _M_ 0 and _θ_ yields parts (i) and (ii) at time 0. From equation (1) manufacturing productivity at time _t_ is an increasing function of the labor supply in manufacturing in all of the the previous periods. Hence, any initial comparative advantage will be magnified over time.

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To establish part (iii) we solve for when _lt_ ( _l_<sup>_∗_</sup> _t_<sup>) are positive.To prove part (iv) we start by taking</sup> the partial derivative of the home and foreign country labor supply in manufacturing in any time period _t_ with respect to the home oil endowment.

Combining these above derivatives along with yields part (iv).

The condition in part (iii) provides a lower bound for manufacturing productivity, or an upper bound for the size of oil endowment, so that a country keeps producing manufacturing goods. In the case where the country no longer produces the manufacturing goods, it obviously still suffers from Dutch disease in our model, however, a further increase in their oil endowment (or their relative productivity) cannot generate a further deterioration in manufacturing. For this reason, the proposition focuses on the more interesting interior solutions.

Proposition 1 shows that oil can generate a Dutch disease effect. Furthermore, it does not require labor shifting to the natural resource sector. On the other hand, as the proof illustrates it does not require non-homotheticity of preferences. All of the results would obtain even if _γ_ = 0. The novel results in proposition 1 occur in part because services are non-traded and because oil production requires no labor. Hence, an increase in the oil endowment allows a country to increase its oil exports, therefore, reduces the need for export revenue from manufactures. Thus allows manufacturing labor to be reallocated to the service sector.

Still, it is important to note that our simple model can produce a Dutch disease effect without labor shifting to the natural resource sector. In addition, as the next proposition shows, it does 12
so without increasing the relative wage of the country that finds the oil. In fact, as a result of the reduction in manufacturing output the relative wage will decrease it in the long run.

**Proposition 2.** _An increase in the oil endowment of the home country does not change the relative home to foreign wage in the short run, but decreases it in the long run._

_Proof._ From equations (10) and (11) the relative home wage is _w_<sup>_<u>w</u>_</sup> _t_<sup>_<u>∗t</u>_=</sup> _M_<sup>_<u>M</u>_</sup> _t_<sup>_<u>∗t</u>_which does not depend on</sup> _θ_ or _θ_<sup>_∗_</sup> .

After any increase in the oil endowment of the home country, the total change in the manufacturing labor productivity at any time _t_ is given by which, from proposition 1, part (iv) is strictly negative as long as _dθτ≥_ 0 for all _τ_ and _dθτ >_ 0 for at least one _τ < t_ .

# **3.2 Unequal oil endowment distribution in the home country**

We now consider the effects of an unequal distribution of the oil revenues in the home country. In this case _κ_ of the home agents have income _w_ + _θ_<sup>_R_</sup> and the renaming 1 _− κ_ have income _w_ . The equilibrium is still described by the pricing, goods, services, and labor market conditions given in equations (6) and (8), however, the aggregate demands for each good and service are different when the agents consume differing bundles.

Rewriting the world trading equilibrium conditions for each market when the home oil endowment is not equally distributed and the rich and poor consume different amounts of goods and services yields the following equations. The world oil market equilibrium is given by 13
From the services market equilibrium in each country we can derive the following wage equations Note that the foreign services market is the same as in the previous section.

The manufactured goods market equilibrium is then described by Note that these equilibrium conditions are derived for the case where the distribution of the oil rents are unequal. We are now in a position to state our main result.

**Proposition 3.** _If oil endowments and initial time zero manufacturing technologies are the same in both countries, then the foreign country will have a comparative advantage in manufactured goods if and only if oil endowments are not equally distributed in the home country._

_Proof._ Using equation (18) to write the ratio of home to foreign manufacturing output in free trade at time 0 yields where _Y_<sup> ̃</sup> ( _κ_ ) = _α_ [( _M_ 0 _κ_ + _M_ 0<sup>_∗_)(</sup><sup>_A_+</sup><sup>_γ_)(1</sup><sup>_−α_) +</sup><sup>_M_0</sup><sup>_A_(1</sup><sup>_−κ_)][1</sup><sup>_−α −β_].If</sup><sup>_M_0=</sup><sup>_M_</sup> 0<sup>_∗_,</sup><sup>_θ_=</sup><sup>_θ∗_, and</sup> _κ_ = 1, then this ratio is equal to one and both countries produce the same output of manufactured goods. If _M_ 0 = _M_ 0<sup>_∗_,</sup><sup>_θ_=</sup><sup>_θ∗_, and</sup><sup>_κ_= 1, then this ratio can be written as</sup> _l_<sup>_<u>l</u>_</sup> 0<sup>_<u>∗</u>_</sup><sup><u>0</u>=</sup><sup><u>[</u></sup><sup>_A_</sup><sup><u>(</u></sup> [(<sup>1</sup><sup>_−_</sup> _A_<sup>_ακ_</sup> + _γ_<sup><u>)+</u></sup> )(<sup>_<u>γ</u>_</sup> 1 _−_<sup><u>(1</u></sup> _α_<sup>_−_</sup> )]<sup>_α_</sup> _X_<sup><u>)</u></sup><sup>_κ_</sup> _−_<sup><u>]</u></sup><sup>_X_</sup> _Y_<sup>_−_</sup> ( _κ_<sup>_Y_</sup> )<sup><u>(</u></sup><sup>_κ_</sup><sup><u>)</u></sup> . To show that this ratio is less than one we must show that [ _A_ (1 _− ακ_ ) + _γ_ (1 _− α_ ) _κ_ ] _<_ [( _A_ + _γ_ )(1 _− α_ )] for all _κ <_ 1. First note that it holds as an equality when _κ_ = 1. Now note that the derivative of the left-hand side with respect to _κ_ is _γ_ (1 _− α_ ) _− αA_ which is positive by assumption (1).

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Proposition 3 complements proposition 1 by showing that it is not only the realization of a natural resource windfall that can generate a Dutch disease effect but it is also the distribution of the resource rents. It provides a possible answer as to why some countries suffer a worse disease after finding a natural resource. Proposition 3 is limited, however, in that it only considers the initial period and only compares equal to unequal distributions. To more fully see the effect of the natural resource distribution on manufacturing and service production we now consider the marginal effect of distribution after any history.

_<u>AMt θ α</u>_ 1 _−α−β Mt_<sup>_∗_</sup> _<u>θ</u>_<sup>_∗_</sup> _<u>α</u>_ 1 _−α−β_ **Proposition 4.** _(i) If AMt_ +( _A_ + _γ_ )(1 _−α_ ) _Mt_<sup>_<u>∗</u>>_</sup> _θ_ + _θ_<sup>_<u>∗</u>_</sup> 1 _−α α_ + _β and Mt_ + _Mt_<sup>_<u>∗</u>>_</sup> _θ_ + _θ_<sup>_<u>∗</u>_</sup> 1 _−α α_ + _β_<sup>_,thenboth_</sup> _countries produce manufactured goods for all κ ∈_ [0, 1] _. (ii) If the condition in part (i) holds and, if θ ≥ θ_<sup>_∗_</sup> _, then a worsening of the resource distribution reduces the output of manufactured goods in the home country and increases their production in the foreign country._ _Proof._ To see part (i) we solve for when _l_ and _l_<sup>_∗_</sup> are strictly positive. First note that _l>_ 0 if From assumption (1) the left-hand side of the above inequality is strictly increasing in _κ_ , therefore if it holds when _κ_ = 0 it must hold for all _κ_ . Substituting _κ_ = 0 into the above expression gives us the first sufficient condition in part (i). The condition for _l_<sup>_∗_</sup> _>_ 0 can be written as Again using assumption 1 we have that the left-hand side of the above inequality is strictly decreasing in _κ_ , therefore if it holds when _κ_ = 1 it must hold for all _κ_ . Substituting _κ_ = 1 into the above expression gives us the second sufficient condition in part (i).

To prove part (ii) we take the partial derivative of the home and foreign country labor supply in manufacturing in any time period _t_ with respect to the index of home resource distribution, while holding the total home endowment constant.
In signing the above derivative we again use assumption (1). In addition, in signing the first derivative we use that _α <_ 1 and that _θ ≥ θ_<sup>_∗_</sup> .

Proposition 4 extends proposition 3 by showing that a worsening of the distribution of the oil endowment causes a deterioration of the home manufacturing base and improves that in foreign. This result holds irregardless of the previous history and irregardless of the manufacturing productivity in period _t_ . In fact, the reduction in home manufacturing is independent of the home manufacturing technology. Greater relative home technology ( _M_<sup>_<u>M∗</u>_) does, however, reduce the for-</sup> eign manufacturing growth that results from worse home resource rent distribution. In addition, note that _θ ≥ θ_<sup>_∗_</sup> is not necessary for the result, therefore, the result could obtain even if _θ < θ_<sup>_∗_</sup> . Finally note that the effect is stronger when services are more of a luxury item ( _γ_ is larger). We state these extensions as a corollary of proposition 4.

**Corollary 5.** _If both countries produce manufacturing goods, then even if the home country has better initial technology in manufacturing and a smaller natural resource endowment, it can still have a comparative disadvantage in manufacturing if it has worse natural resource rents distribution._

Finally, we show that the Dutch disease can arise solely from less equal natural resource rents distribution. Furthermore, this Dutch disease effect exists without labor shifting to the natural resource sector or without increasing the relative wage of the country with worse resource rent distribution. In fact, as a result of the reduction in manufacturing output, the relative wage will decrease in the long run.

**Proposition 6.** _A worsening of the home country resource rent distribution can generate manufacturing stagnation. It does so without a change in the relative home to foreign wage in the short run and with a decrease in the long run._

_Proof._ From equations (10) and (11) the relative home wage is _w_<sup>_<u>w</u>_</sup> _t_<sup>_<u>∗t</u>_=</sup> _M_<sup>_<u>M</u>_</sup> _t_<sup>_<u>∗t</u>_which does not depend on</sup> _κ_ , _θ_ or _θ_<sup>_∗_</sup> .

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After any change in the resource rent distribution of the home country, the total adjustment in the home manufacturing labor productivity at any time _t_ is given by which, is strictly negative as long as _dκ <_ 0 by proposition 4, part (ii). Similarly, the total change in foreign manufacturing labor productivity is

# **4 Conclusion**

In this paper we demonstrate that the Dutch disease effect may arise solely from demand considerations without productive factors moving to the resource sector, without any wage increase, and without any currency appreciation. First, we show that it can arise solely from increased demand for non-traded services. Second, we show that this increased demand is augmented by unequal distribution of the resource rents. As services become more of a luxury item and/or the resource rents are less widely distributed, the Dutch disease is more pronounced. Our results suggest why some countries, therefore, have a greater chance of suffering the curse.

Our emphasis on the importance of resource rent distribution for Dutch disease effects resonates with recent thinking that the resource curse is generally seen as conditional on poor political governance (see for example, Elbadawi and Soto 2012 and Acemoglu and Robinson 2012). The stark political reality of resource discoveries is that rents are often contested in the context of highly unbalanced and non-inclusive power structures that privilege short-term personal enrichment over long-term collective welfare enhancement (Barma et al 2012). It is intuitive to view these features as modalities for motivating our modeling of unequal distribution of resource rents, and they will remain important policy issues in these countries for some time. As much as institutional quality 17
is correlated with income and natural resource rent distribution, then our model suggests that the effect may exist at a more primitive distributional level.<sup>12</sup> We leave further development of these ideas for future research.

Our analysis also relates to a recent debate evolving around optimal use of resource revenues in developing countries. Devarajan and Giugale (2013) make the case for universal and uniform direct payments to the population in resource rich African countries, which could lead to a reduction in poverty and enhancement in social welfare. Although we do not consider alternative mechanisms, our main result demonstrates that equality in distribution of natural resource rents could be an important factor to cope with Dutch disease dynamics. Future contributions to this discussion should explicitly consider the mechanisms through which natural resource rents are allocated.<sup>13</sup> It may also be worthwhile to consider the introduction of traded services into the analysis. In particular, with learning-by-doing in tradable services, a resource rich country (or one that receives large foreign transfers) could develop a comparative advantage in the provision of luxury services.

# **References**

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- [3] Barma, N.; K. Kaiser; T. M. Le and L. Viñuela (2012). “Rents to Riches? The Political Economy of Natural Resource Led Development.” Washington, DC: World Bank Press.

> 12Recent research by Law et al (2014) shows that income inequality is negatively correlated with institutional quality. 13An important observation here is that different allocation mechanisms may not be perfect substitutes. For example, remittances or foreign aid are conventionally considered to be analogous to natural resource finds in the literature. Although all these channels denote a windfall, the channels of injection to the economy could be different. Whereas the natural resource rents may be captured by elites who already represent the upper segments of the income distribution, remittances may be associated with poor or middle-class households on the receiver ends. Our framework, therefore, shows that natural resource finds and remittances may have different Dutch disease implications.

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