Use the production frontier diagram to illustrate how the resource price increase affects output of the resource and manufacturing sectors.

Assignment Brief

Consider the simple version of the Dutch Disease model as discussed in class and in the lecture notes. There two industries - resource extraction (R) and manufacturing (M). The production functions are given by: M=F(LM,KM ) R=G(LR,KR) where Ki denotes factors that are specific to sector i, and Li denotes the employment of intersectorally mobile factors used in sector i. To be concrete, think of L as labour that can move freely between sectors and think of K as capital is that tied to a particular sector. In the case of resources, we should think of KR as including both physical and natural capital (including resource deposits). Assume a small open economy so that prices PM and PR are exogenous.

Suppose that pR rises (which causes a resource boom).

• Use the production frontier diagram (as in Fig. 1 of the notes) to illustrate how the resource price increase affects output of the resource and manufacturing sectors.
• Use the labour market diagram (Figure 2 in the notes) to illustrate how the resource price increase affects employment in the resource and manufacturing sector.
• Suppose there is immigration in response to the resource boom. That is, the supply of labour increases.
• Use the labour market diagram (Figure 2 in the notes) to illustrate how immigration that occurs after the resource price increase affects employment in the resource and manufacturing sector.
• What is the effect of immigration on the wage?
• Is it possible for immigration to prevent the manufacturing sector from contracting, or will it just affect the resource sector?

Consider the alternative simple version of the Dutch Disease model as discussed in class and in the section3 of lecture notes where there is a spending effect. The resource sector is assumed to employ no domestic labour - it simply generates a large flow of income for the economy. The production function for manufacturing is M=F(LM,KM ) where LM is capital that can be used only in manufacturing. The production function for non-traded services is N=H(LN,KN). KN is capital that can be used only in the nontradable sector. Since we are assuming that domestic labour is not used in the resource sector, the full employment condition is: LM +LN =L

The price of manufactures is exogenous, but the price of nontraded services is determined by domestic demand and supply

Suppose there is a resource boom so that the flow of income to the economy from the resource sector increases. Suppose that the government uses taxes to collect half of the increase in resource income and uses this to invest in infrastructure for the resource sector (this means that KR rises).

• Use a production frontier diagram (as in Fig. 3 of the notes) to illustrate the combined effects of the resource boom and the government`s infrastructure policy on output.
• Use the labour market diagram (Figure 5 in the notes) to illustrate the combined effects of the resource boom and the government`s infrastructure investment on the labour market (i.e. how are employment in the two sectors and the wage different when the government implements the infrastructure policy during the resource boom as compared to when the resource boom happens with no infrastructure policy?

Suppose there are two industries, resources and manufacturing, with production functions R=G(LR,KR) Mt =AtF(LM ,KM ) where At is a productivity parameter at time t and the inputs L and K in each sector are defined as in question 1.

Assume that productivity in manufacturing evolves over time according to: At = At−1 +βI where It is infrastructure (roads and airports) at time t. It = It−1 +γ(pRRt−1 + pM Mt−1)

That is, government spending on infrastructure is increasing in total GDP. Goods prices are assumed fixed. Consider two countries (Home and Foreign) that are completely identical at time 0. A resource boom occurs at Home in period 1 (KR rises at home). The resource boom is over in period 2, and so at home KR drops back to the same level it was at in period 0. So in period 2, KR and KM are the same in home and foreign again. Use the production frontier and a labour market diagram to compare Home and Foreign in period 2. Which country has a higher GDP in period 2? Which country has a higher wage? Which has higher employment in manufacturing? Explain.

Sample Answer

Dutch Disease Model Assignment Answer

Question 1: The Basic Dutch Disease Model

(a) Effect of a Resource Price Increase Using the Production Frontier Diagram

In the basic Dutch Disease model, we have two industries: manufacturing (M) and resource extraction (R). Each uses a sector-specific capital (K) and intersectorally mobile labour (L). When the price of resources (pR) increases, the resource sector becomes more profitable. As a result, the resource sector demands more labour, drawing it away from the manufacturing sector.

In the production frontier diagram (Fig. 1), this is illustrated as a movement along the production possibility frontier (PPF) towards more R and less M. The economy reallocates resources to produce more in the booming resource sector. The output of M decreases while R increases.

(b) Effect of Resource Price Increase on Labour Allocation

In the labour market diagram (Fig. 2), wages increase due to the higher marginal revenue product of labour in the booming resource sector. This leads to a reallocation of labour from manufacturing to resource extraction. The equilibrium wage rises, but employment in manufacturing falls while employment in the resource sector increases.

(c) Immigration Response

(i) Effect on Employment

If immigration occurs and the labour supply increases, the labour market diagram shifts outward. With more workers available, both sectors can employ more people. The inflow of workers helps reduce the upward pressure on wages, which may allow the manufacturing sector to regain some of the labour it lost.

(ii) Effect on Wages

Immigration moderates the wage increase caused by the initial resource boom. With a larger supply of labour, the equilibrium wage is lower than it would be without immigration.

(iii) Can Immigration Prevent Manufacturing Contraction?

Yes, it is possible. If the inflow of labour is sufficient, the manufacturing sector can maintain its employment levels. In some cases, it may even expand if wage costs are stabilised. However, this depends on the scale of immigration and labour market flexibility.

Question 2: Dutch Disease with Spending Effect

In this version of the model, the resource sector employs no domestic labour but generates income. This income increases demand for non-traded services (N), raising their price.

(a) Effect on Output (Production Frontier Diagram - Fig. 3)

The resource boom increases national income. As people spend more on non-traded services, labour shifts from manufacturing to services. This is illustrated in the production frontier by a shift towards more N and less M. However, the government uses taxes to invest in infrastructure, raising KR (capital in the resource sector). This investment supports future growth but also alters the allocation of resources.

(b) Effect on Labour Market (Labour Market Diagram - Fig. 5)

Without government investment, labour shifts away from manufacturing to services due to increased demand. Wages rise. With infrastructure investment, the impact is less severe on manufacturing. Investment supports manufacturing productivity and helps retain employment in that sector. As a result, the wage increase is moderate, and employment is better distributed between N and M.

Continued...