Natural resources, rent seeking and welfare

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Abstract

A new and very simple mechanism to explain why natural resource abundance may lower income and welfare is developed. In a model with rent seeking, a greater amount of natural resources increases the number of entrepreneurs engaged in rent seeking and reduces the number of entrepreneurs running productive firms. With a demand externality, it is shown that the drop in income as a result of this is higher than the increase in income from the natural resource. More natural resources thus lead to lower welfare.

Introduction

Why are so many countries poor even though they are rich in natural resources? This puzzle, documented in, for example, Sachs and Warner (1995) and Gylfason et al. (1999), has attracted two different kinds of answers from economists. The ‘Dutch disease’ literature emphasizes that an abundance of natural resources shifts factors of production out of sectors where production exhibits static or dynamic increasing returns to scale. In van Wijnbergen (1984), Krugman (1987), Matsuyama (1992) and Gylfason et al. (1999), there is learning by doing in one sector, and an abundance of natural resources may shift factors of production away from that sector, pushing down productivity growth. Sachs and Warner (1995) also assume that only one sector generates learning by doing, but assume a perfect spillover to the rest of the economy. An increased amount of natural resources then lowers productivity growth in all sectors. Torvik (2001) studies the case where all sectors contribute to learning and there are spillovers between them. Then, an abundance of natural resources may lower growth, depending on the structural characteristics of the economy at hand. Natural resource abundance in a big push model is studied by Sachs and Warner (1999). When one sector has constant returns to scale while the other has increasing returns to scale, more natural resources may lower production if it is the traded sector that has increasing returns to scale. All the Dutch disease papers concur that abundant natural resources may lower production and welfare because the composition of production is changed, and because it is the composition of production that determines the level or the growth rate of productivity.

Another answer to why more natural resources may lower production and welfare is rent seeking. Lane and Tornell (1996) and Tornell and Lane (1999) show that in an economy with multiple powerful groups that each has open access to production, higher productivity may in fact push the rate of return on investment and thus, growth, down. The reason for this is that when productivity increases, each group attempts to acquire a greater share of production by demanding more transfers. In turn, more transfers increase the tax rate and reduce the net return on capital. This redistribution effect may outweigh the direct effect of increased productivity. In Lane and Tornell (1996), growth falls as a result of decreased savings, while in Tornell and Lane (1999), growth falls because capital is reallocated to the less productive informal sector, where it is safe from taxation.1 Baland and Francois (2000, p. 529) focus on multiple equilibria in a model with rents generated by import quotas. With an increase in the primary factor of production, they obtain the result that: “when a large proportion of individuals are engaged in rent seeking already, such an increase inclines the economy towards more rent seeking and may actually lead to a decline in aggregate income.” The reason for this is that with an increase in the primary factor, the value of an import quota increases more than that of productive production, pulling resources out of production and into rent seeking.

To clarify how the present mechanism differs from the Dutch disease literature and from the more recently proposed rent-seeking models, we start out by imposing assumptions that rule out the mechanisms behind the earlier results. First, we assume that the natural resource does not alter the composition of production. The simplest way to do this is to assume that the natural resource consists of the same goods as those previously produced in the economy. Second, we assume a constant tax rate. Then, it is not possible for an increased amount of natural resources to push the tax rate up, leading investors to retain a smaller fraction of the profit from an investment, as in the papers by Lane and Tornell. Third, we assume an economy without external trade, so that no rents can be created as a result of the trade regime. Later, we study effects of relaxing these three assumptions.

Section 2 sets out a simple model with increasing returns to scale and rent seeking, while Section 3 discusses the equilibrium of the model. The main result in the paper, the effects on production and welfare of an increase in natural resources, is discussed in Section 4. Furthermore, since the model is set up so that the same experiments as in Lane and Tornell (1996), Tornell and Lane (1999) and Baland and Francois (2000) may be undertaken, Section 4 also compares the model to these related models. It turns out that the mechanisms highlighted in the present paper provide opposite results to both of these approaches. Since we have assumed away the mechanisms leading to the results in these papers, it should be highlighted that rather than being an alternative, the present paper complements these approaches by pointing out some new mechanisms.

The three assumptions in the basic model are then relaxed in Section 5. It is shown that if the tax rate increases with the number of rent seekers, the mechanisms behind the results in the basic model are strengthened. In an open economy version of the model, we study the effects from demand composition, and show that in the present model these generate productivity implications different from traditional Dutch disease models, as well as from the open economy model in Murphy et al. (1989b). The latter suggest that natural resources will increase productivity in the nontraded sector when this is subject to increasing returns to scale in production. Section 6 offers some concluding remarks.

Section snippets

The model

There are a given number of goods normalized to one, and an equal number of entrepreneurs. In addition, the economy is populated by L workers. There are four sectors. First, a natural resource sector contributes R units of goods without any input requirements. Second, a backward sector produces with constant returns to scale (CRS). In CRS production, it takes one unit of labor to produce one unit of any good. Third, a modern sector produces with increasing returns to scale (IRS). IRS production

Equilibrium

Two conditions have to be fulfilled for the economy to be in equilibrium. First, the allocation of entrepreneurs must be such that no entrepreneurs wish to shift between activities. If we do not have a corner solution, this implies that the payoff to entrepreneurs from modern production must equal the expected payoff from rent seeking:π=πG

Second, total supply of goods must equal total demand of goods. Total supply of goods is given by y+R. Total demand for goods equals total income, since there

Natural resource abundance, income and welfare

The effects of an increase in the natural resource is summarized in the following proposition:

Proposition 1

An increased amount of natural resources decreases total income and welfare.

The proof of this result is straightforward. The profit curve for modern production in Fig. 1 is not affected by increased R. From Eq. (8), it is easily seen that with a higher R, it becomes more profitable to be a rent seeker at all levels of rent seeking. The profit curve for rent seeking thus, shifts up to the dotted curve

Endogenous tax rate

In the basic model laid out in Section 2, the tax rate is exogenous and thus, independent of the number of rent seekers. It can be argued, however, that at least for certain forms of rent seeking, more rent-seeking activity implies more redistribution from producers to rent seekers. We now extend the model to take this into account by looking at the alternative assumption that each new rent seeker can extract the same share of production as the previous ones. In this way, our model may be

Concluding remarks

A new and very simple mechanism explaining why natural resource increases may decrease welfare and income has been developed. The mechanism is the result of the combination of rent seeking and increasing returns to scale. Although the model is constructed in the simplest possible way to capture the idea that more natural resources may lower welfare, the mechanisms may also apply to other types of exogenous increases in income, such as foreign aid or regional transfers.

In general in this type of

Acknowledgements

I have benefited from the comments of Halvor Mehlum, Jørn Rattsø, seminar participants at the Central Bank of Norway and two anonymous referees.

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