'DUTCH DISEASE': THE PERVERSE EFFECTS OF A RESOURCE BOOM IN A SMALL OPEN ECONOMY (DEINDUSTRIALIZATION, WELFARE ANALYSIS)

The welfare and factor allocation effects of a resource boom in a small open economy are studied. Variations of a two sector general equilibrium model are developed where the movement of factors of production between the traded (manufacturing) and the non-traded (service) sectors provide the basis for the analysis of 'Dutch Disease'. Such factor movement is due to a resource boom which is thought of as increased transfer income from abroad. Assuming price and wage flexibility, perfect mobility of factors of production, and perfect foresight, the welfare effects of a resource boom are studied under the following assumptions: external economies in the production of the traded good, imperfect competition in the market for the traded good, the existence of a distortionary wage tax system, and the presence of unobservability and asymmetric information in the market for non-homogeneous labor. It is shown that given some conditions, introducing each of the above assumptions may bring about a negative welfare effect resulting from the relative contraction of the traded sector due to a resource boom. This process, called deindustrialization, occurs due to a change in the real exchange rate which affects the relative profitabilities of the traded and the non-traded sectors. It is shown that a resource boom, usually thought of as synonymous with prosperity, may in fact exacerbate externalities and imperfections inherent in the economic system, causing a decline in consumption and a subsequent loss of welfare. The analysis suggests some government policies that mitigate or eliminate the negative welfare effects of a resource boom in the described economies.