C. Trade theory and natural resources - World Trade Organization

world Trade reporT 2010

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This section looks at key features of natural resources trade from a theoretical perspective. Does trade provide an efficient mechanism for ensuring access to natural resources? What is the impact of trade on finite or exhaustible resources, including under conditions of “open access” where there is a common ownership of – and access to – a natural resource? Is there a relationship between trade and its impact on the environment? Does trade reinforce or reduce problems associated with resource dominance in certain economies? And how does trade affect resource price volatility? These broad questions are addressed by surveying the relevant theoretical literature on the determinants and effects of trade in natural resources.

C. Trade theory and natural resources

II – tRADe In nAtuRAL ResouRces

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Contents 1. Tradetheoryandresourcedistribution 74

2. Tradetheoryandresourceexhaustibility:Theproblemoffinitesupplies 75

3. Tradetheoryandresourceexhaustibility:Theproblemofopenaccess 81

4. Naturalresourcesandtheproblemofenvironmentalexternalities 87

5. Thenaturalresourcecurse 91

6. Naturalresourcesandpricevolatility 97

7. Conclusions 107


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1. Tradetheoryandresourcedistribution

Countries’ differing natural resource endowments –and their uneven geographical distribution – play acriticallyimportantpartinexplaininginternationaltrade.Traditionaltradetheoryemphasizesthatdifferencesinfactorendowmentspromptcountriestospecialize,andtoexportcertaingoodsorserviceswheretheyhaveacomparativeadvantage.Thisprocessallowsforamoreefficientallocationofresources,whichinturnleadstoan increase inglobal socialwelfare– the “gains fromtrade”.

Relativedifferencesincountries’resourceendowmentsarekeytothestandardversionoftheHeckscher-Ohlintheoryofinternationaltrade.Thisstatesthatacountrywillexportthegoodwhichrequirestheintensiveuseofthecountry’srelativelyabundant(andthereforecheap)factor for its production, and import the good whichrequires the intensive use of the country’s relativelyscarce (and therefore expensive) factor for itsproduction. This includes cases in which the naturalresourceisdirectlyexported(afteraminimalamountofprocessing), rather than being used as an input inanothergoodthatislatersoldininternationalmarkets.

Hence, endowments of immobile and scarce naturalresourcesmayformasourceofcomparativeadvantagethatguidesthepatternofinternationaltrade.Consistentwith this theory, Leamer (1984) finds that the relativeabundanceofoil leadstonetexportsofcrudeoiland

thatcoalandmineralabundanceleadstonetexportsofraw materials. Trefler (1995) finds similar results withrespect to trade in resource-intensive goods. Whilemostofthereportfocusesontradeinnaturalresources,Box4providesanexampleofthestaticgainsassociatedwithtradeingoodsthatembodyaresource(water).

The Heckscher-Ohlin theory has been modified andextendedbyintroducingotherfactorsbesidesresourceendowments,suchastransportationcosts,economiesof scale and government policy,1 that also influencecomparative advantage. For example, distance fromworldmarketscanbeadecisivefactorwhenthenaturalresourceinquestionisbulky,suchasnaturalgas,andwhen transportation costs are high. Complementaryinputs, such as technology, capital and skilled labour,are also significant when a natural resource sector ischaracterized by difficult or technically complexextractionprocesses.

Variables such as education, infrastructure andinstitutionshavealsobeenobservedtoaffectsectoralpatternsofnaturalresourcestrade(LedermanandXu,2007). Only when these other determinants ofcomparative advantage are in place will a resource-abundantcountrytendtoexportresourcestocountrieswitha relativeabundance incapitalandskilled labourand import capital-intensive goods in return (Davis,2009). In short, natural resource endowments mayrepresent a necessary but not sufficient condition forthe production and export of resources or resource-intensivegoods.

Box4:virtual trade in water

Tradecanhelptoaddressproblemsrelatedtotheunequalgeographicaldistributionofanaturalresourcewhenitisthegoodsembodyingthatresourcethatareexchangedratherthantheresourceitself–asisthecasewithtradein“virtualwater”.

Growingfoodwherewaterisabundantandtradingitwithareaslackinginfreshwaterhasthepotentialtosavewaterand tominimizenew investments indams,canals,purificationsystems,desalinationplantsandotherwater infrastructure.Ricardo’s theoryofcomparativeadvantagehasbeenextendedtoexplain theeffectofwateravailabilityoninternationaltrade(Wichelns,2004).Thistheoryof“virtualwatertrade”suggeststhattheimportationofawater-intensivecommodityisattractiveiftheopportunitycostofproducingthatcommodityiscomparatively high due to scarce freshwater reserves or low water productivity. Similarly, exporting thesecommoditiesisattractivewhenfreshwaterreservesareabundantorproductivityishigh.

It follows that countries facing freshwater scarcity should import water-intensive products and export lesswater-intensiveproducts.Theycanconsequentlysavedomesticfreshwateranddirect it towardsproducingwater-intensiveproductswithhighermarginalbenefit.Giventhatagricultureaccountsforalmost90percentoftotalfreshwaterusage,internationaltradeinagriculturalcommoditiescouldplayamajorroleinaddressingtheproblemofwaterscarcity.

Thereisclearempiricalevidencethattradeinwater-intensiveproductssavesfreshwater(Hoekstra,2010).Themostcomprehensivestudyonthissubjectfoundthatsome352billionm3ofwaterisalreadysavedeachyearbytradeinagriculturalproducts(Chapagainetal.,2006).TableAshowsthenetwatersavingsachievedthroughvirtualwatertradeforaselectionofcountries.Japan,whichwasthe largestnet importerofwater-intensivegoodsovertheperiod1997-2001,wasabletosavealmostfourandahalftimesitsdomesticuseofwaterthroughtradeinvirtualwater(Hoekstra,2010).


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2. Tradetheoryandresourceexhaustibility:Theproblemoffinitesupplies

Adefiningfeatureofnon-renewablenaturalresourcesis theirfiniteavailability–and the fact thatextractionandconsumptiontodayirreversiblyalterstheextractionand consumption possibilities of future generations.The traditional model of trade discussed above doesnot directly address this problem of exhaustibility andthe inter-temporal trade-offs involved. Understandinghowtradeimpactsontheexploitationofnon-renewablenaturalresourcesinvolveslookingbeyondthestandardversionof theHeckscher-Ohlinmodel,andadoptingadynamicapproach that takes intoaccount thechangeovertimeintheavailabilityofafiniteresource.

(a) Efficientresourceextraction:TheHotellingrule

Inhispioneeringworkontheeconomicsofexhaustibleresources,Hotelling(1931)developedaframeworkforpredictingthebehaviourofpricesandextractionpathsin light of inter-temporal trade-offs – or “depletionopportunitycosts”.2 Indoingso,headdressedtwokeyquestions: how should a resource be extracted overtime in order to maximize the welfare of current andfuture generations, and can economic competitionsustainthesocialoptimumlevelofextraction?Althoughheworkedwithinaclosed-economymodel,hisinsightsprovide a benchmark for understanding how tradeimpacts on non-renewable resources in openeconomies.

Inresponsetothefirstquestion,considerthecaseofasocialplannerwhochoosesaresourceextractionrateto maximize the welfare of current and futuregenerations.Theplannerunderstandsthat,dueto thefixedsupplyoftheresource,anychangeintherateofextraction inoneperiodwill triggeranoppositeeffectat some later period, with negative consequences forthe welfare of later generations (i.e. an increase inconsumption of the resource today may benefit thecurrentgeneration, but itwill reduce theconsumptionpossibilities of a future generation). According to theHotellingrule,thesocialoptimumisachievedwhenthepriceoftheresourcenetofextractioncostsgrowsatarateequaltotherateofinterest.This,inturn,determinestheefficientpathofextractionofthenaturalresource.Inessence,whenthepresentvalueofoneunitextractedis equal in all periods, there is no social gain fromincreasing or reducing the amount of the resourceavailableineachperiod(DevarajanandFisher,1981).

The second question is, how does the extraction ratedescribed above compare with that of a competitive,profit-seekingentrepreneur?Inotherwords,shouldweassumethatcompetitionwillleadtoover-exploitationofnon-renewable natural resources? To answer thisquestion, imagine that the world lasts two periods:todayandtomorrow.Assumethatthemarginalcostandtheaveragecostofresourceextractionarenegligible,so that they can be set equal to zero. Under thisscenario, the resource owner faces the dilemma ofwhether toextractall theresourcetoday, tomorrowortosplittheextractionbetweenthetwoperiods.Hisfinaldecisionwilldependonthepriceoftheresourceinthetwoperiods: thehigherthepricetomorrow, thehigherthe profits from future extraction and the lower theincentivetoexploittheresourcetoday.

However, trade invirtualwatercanalsohaveanegative impactonwaterconservationwhen the incentivestructures are wrong. For instance, according to Hoekstra and Chapagain (2008a), Thailand experienceswater shortages partly because too much water is used to irrigate rice crops for export. Similarly, KenyadepleteswaterresourcesaroundLakeNaivashatogrowflowersforexport.Inanotherstudy,NascimentoandBecker (2008) find that fruit exporters in the São Francisco River region in Brazil are prospering in partbecauseofanartificiallylowpricingsystemforwater.Inshort,tradeinvirtualwatercanexacerbate,ratherthan reduce,waterscarcityproblemsunlessexportingcountriesaccount fully for theopportunitycostsoffreshwateruseandaddressanypotentialnegativeenvironmentalimpacts.Aproperlymanagedwatersectoriskeytoensuringthatvirtualwatertrademaximizestheproductivityofthisscarceresource–apointwhichwillbeexploredindetailinSectionsC.3andC.4.

TableA:examples of nations with net water saving as a result of international trade in agricultural products, 1997-2001

Country

Totaluseofdomesticwaterresourcesinthe

agriculturalsector1

(109m3/yr)

Watersavingasaresultofimportofagricultural

products2

(109m3/yr)

Waterlossasaresultofexportofagricultural

products2

(109m3/yr)

Netwatersavingduetotradeinagricultural

products2

(109m3/yr)

Ratioofnetwatersavingtouseofdomesticwater

(percent)

China 733 79 23 56 8

Mexico 94 83 18 65 69

Morocco 37 29 1.6 27 73

Italy 60 87 28 59 98

Algeria 23 46 0.5 45 196

Japan 21 96 1.9 94 448

1Source: HoekstraandChapagain(2008a).2Source: Chapagainetal.(2006).Agriculturalproductsincludebothcropandlivestockproducts.


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Figure12capturestheessenceofthedilemmaofwhento extract resources. The horizontal axis is the totalamount of the resource. Consumption in Period 1 ismeasuredfromlefttoright,whileconsumptioninPeriod2ismeasuredfromrightto left.Thetwoverticalaxesmeasurethepriceoftheresource.Ontheleft,thereisthepriceinPeriod1,whiletherightaxisisthepriceofPeriod2discountedtothefirstperiod(i.e.thepresentvalueofthefutureprice).Finally, thetwolinesarethedemand curves of the resource in the two periodswhich,asusual,aredownwardslopingas thequantitydemandedincreasesasthepriceoftheresourcefalls.

The equilibrium is at point E, where the two demandcurves intersect and where a producer is indifferent

betweensellinganextraunitoftheresourceinthefirstorinthesecondperiod.TheequilibriumpricepEissuchthatp=p2/(1+r) where r is the interest rate, while theequilibrium consumption (and extraction) of the twoperiodsaregivenbythesegments(O1-QE)forPeriod1and(O2-QE)forPeriod2respectively.Itisinstructivetounderstand why the competitive equilibrium is the onethatcorrespondstotheHotellingrule.Ifp2isgreaterthan(1+r)p1,itwillbemoreprofitablefortheresourceownertoextract tomorrow and not today, which will reduce thepriceoftheresourcetomorrowandincreasethepriceoftheresourcetodayuptothepointwheretheequalitywillberestored;whileifp2islessthan(1+r)p1,itwillbemoreconvenient to increase the extraction of the resourcetoday,withtheoppositeeffectonprices.

In a competitive setting, price is usually equal to themarginalcostofproduction.Butinthisframework,theprice ishigherbecausetheresourceownertakes intoaccount the depletion opportunity cost in addition tothemarginalcostofproduction(i.e.theextractioncost).If he did not take the depletion opportunity cost intoaccount,currentprofitswouldcomeattheexpenseoffuture profits, which is inconsistent with the profit-maximizing behaviour of competitive entrepreneurs.Since the depletion opportunity cost is taken intoconsideration by producers, the competitive outcomewillbeequaltothesocialoptimum.Inessence,Hotellingdemonstratedthatacompetitiveproducerbehaveslikeasocialplanner,takingintoaccounttheconsequencesofdepletingresourcesbyextractinglesstoday.

However, inpracticetheHotellingrulehasnotprovedanaccuratepredictoroftheevolutionofobservedpricetrends for non-renewable resources. According to hismodel,pricesofnon-renewableresourcesshouldhaveincreasedover time,whereas in fact theyhavemovederratically.This is largelybecausetheHotellingmodeldoes not take into account other important factorsinfluencingpricetrends,suchasthefactthatthemarket

structureof non-renewable resource sectors is bettercharacterized as imperfect (such as monopoly oroligopolisticproducers)ratherthanperfectcompetition,thaton-going technological changesaffect incentivesto extract resources, that extraction costs tend toincrease over time (e.g. digging deeper mines)(Hotelling, 1931; Peterson, 1975; Weinstein andZeckhauser, 1975) and that uncertainty regardingfuturesupplyanddemandaffectsdecisions(ArrowandChang,1978;Hoel,1978;DevarajanandFisher,1981;Weinstein and Zeckhauser, 1975).3 Several of thesespecificpointswillbeanalysedbelow.

(b) Heckscher-Ohlinmodelinthecontextofnaturalresources

DothemainpredictionsoftheHeckscher-Ohlintheorycontinuetoholdwhenexhaustiblenaturalresourcesareusedas factorsofproduction– including thesituationwheretheyaresolddirectlyininternationalmarkets?

Onestudydevisedthefollowingthreescenariostotestthetheory’svalidity(KempandLong,1984).Inthefirstscenario (defined as the Anti-Heckscher-Ohlin

Figure12:Perfect competition and the Hotelling rule

p1

p2

/(1+r)

pE

D1

D 2

O1 Period 1 Consumption QE Period 2 Consumption O2

Total Resource Stock

E


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model), each final good is produced using only twoexhaustibleresources. Inthesecondcase(referredtoastheHybridmodel),oneofthetworesourcesusedinproduction is exhaustible (as in thefirstmodel),whiletheother isnot (as in thetraditional theory).Thethirdscenario assumes that the production of final goodsrequires that two non-exhaustible resources arecombined with an additional exhaustible resource(Generalized Heckscher-Ohlinmodel)(KempandLong,1980;KempandLong,1982).

Whatwasfoundundereachscenario4isthatacountrywhich is initially relatively well endowed with a non-renewable resource will specialize in that resourcesector–and/or in theproductionofgoodswhicharerelativelyintensiveintheuseofthatresource.Inotherwords, even when finite resources are involved, tradepatterns(i.e.whatcountriesexportandimport)arestillexplained by comparative advantage driven bydifferences in resource endowments.5 Welfare gainsfrom trade are still possible because specializationallowsfortheefficientallocationoflimitedresources.

Importantly, in this environment there is no over-exploitationofthenaturalresourceasextractionisset(eitherbyasocialplannerorbycompetitiveproducers)to maximize social welfare of present and futuregenerations.Thisisnottosaythattradeneverleadsto

over-exploitation of finite resources, but rather thatover-exploitationisaffectedbytradeopeningonlywhenmarket failures (such as imperfect competition orexternalities) or political economy failures (such asrent-seekingorcorruption)areinvolved.6

(c) Imperfectlycompetitivemarkets

So far the discussion has not departed from thetraditionalassumptionsthatmarketsareperfect,firmsproduce under constant returns to scale and that allstagesofproductionoccurinthesamelocation.Undertheseassumptions,theeconomicliteratureshowsthatthe predictions of standard trade theory hold true –namely, that under free trade, countries specializeaccordingtotheircomparativeadvantageandexchangedifferentgoods.

However,severalfeaturesofnaturalresourcemarketsmakethemparticularlypronetovariousformsofmarketpower. First, the fact that natural resources are oftenconcentrated infewcountries increasesthescopeforcollusion and limits the scope for the development ofperfectly competitive markets. Second, the relativelyscarce supply of many natural resources createspotential for extracting “scarcity rents” (see Box 5)whichinturnencouragesrent-seekingactivities.Third,duetothehighfixedcostsofextraction,productionand

Box5:What is a rent?

Ineconomics,theconceptofeconomicrentisequivalenttothatof(positive)economicprofit–thatisareturninexcessofnormalprofit,wherethelatteristhereturnthatanentrepreneurshouldearntocovertheopportunitycostofundertakingacertainactivityratherthanitsbestalternative.Inotherwords,anyrevenueexceedingtotalcostsincludingtheopportunitycost(ornormalprofit)iseconomicrent(oreconomicprofit)(McConnellandBrue,2005).

Economistsgenerallydistinguishthreetypesofrents:

1. Differential or Ricardian rent

Theclassicalnotionofdifferentialrentisrelatedtoland.Theideaisthatgreaterrentaccruestolandofhigherproductivity and better quality (e.g. greater fertility), with marginal land receiving no rent. More generally,differential or Ricardian rents arise when producing firms operate under different conditions – that is, atproductionsiteswithmoreorlessfavourablecharacteristics.Forexample,theremaybedepositsfromwhichitiseasierandcheapertoextractoilormineralresources;asaconsequence,somefirmsfacelowerorhighercoststhanothersandearnmoreorlessthanothers,respectively.

2. Scarcity rent

Scarcityrentsarisewhentherearerestrictionsonthesupplyofanaturalresource,sothatdemandexceedssupply. These restrictions can be natural or legal. Natural limitations exist because natural resources aregenerally available in finite amount, whereas legal limitations can derive from an export or a productionrestriction.

3. Quasi-rent

Quasi-rents are attributable to entrepreneurial skills and managerial efforts. Firms can adopt innovativepracticesandundertakestrategicinvestmentsinadvertising,trainingofemployeesandsoon,therebyattaininghigherprices(e.g.betterreputation,higherproductivity)orlowercosts(e.g.bettertechnology).

Ingeneral,theresourcerentisthetotalofthedifferentialrentandthescarcityrent.Quasi-rentscanalsoberesource rentswhen theyaccrue tonatural resources.Thefundamentaldifference is thatwhiledifferentialrentsandscarcity rentsexisteven inmarketscharacterizedby freeentryandperfectcompetition (as theyrelatetotheinnatecharacteristicsofnaturalresources),quasi-rentsaredriventozeroascompetitorsadoptprofitablestrategiesaswell(VanKootenandBulte,2000).


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transportation that many resource-based companiesface,naturalresourcesectorstendtoexhibitincreasingreturnstoscale7–whichcaninturnleadtoimperfectcompetition. Finally, some natural resource marketshave a monopsonistic structure – that is, they arecharacterized by a dominant buyer – representinganotherdeparturefromperfectcompetition.

Thefollowingdiscussionlooksattheoptimalextractionpath for finite natural resources under imperfectcompetition,andthenexplainstheimplicationsfortradein thesekindsof commodities.Since the literatureonnaturalresourcestradeunderimperfectcompetitionisfragmentary, the question of how trade impacts onresource sustainability can only be answered forspecificcircumstances.

(i) Market structure and optimal extraction of exhaustible natural resources

Cartels provide the simplest case of imperfectcompetition that can be analysed in an inter-temporaleconomic model – the model which, as noted above,best reflects theexhaustiblenatureofnon-renewablenatural resources. Because other forms of imperfectcompetition, such as duopolies or oligopolies, involvestrategic interactions among agents, they introduce anumber of analytical complexities which limit themodel’sapplicabilityandrelevance.8

Ingeneral,economictheorysuggeststhatan imperfectmarket structure will generate a dynamically inefficientoutcome with a bias towards the initial conservation ofnon-renewable resources – a result that holds true formonopolies, core-fringe market structures, oligopoliesandmonopsonies.9Inthecaseofafullycartelizedmarket,theintuitionisasfollows:whenanaturalresourcescartelincludesallproducers, itwillbehaveasa fullmonopoly.Given world demand for the cartelized commodity, themonopolistwillateachmomentintimesetpricesatthepointonthedemandcurvecorrespondingtothequantitywhere marginal cost equals marginal revenue. In otherwords, the monopolist at each moment in time will setpricesatalevelabovemarginalcost.10

Therefore, as with the static theory of cartels, non-renewable natural resource cartels will restrict outputrelative to the output of a perfectly competitive (oroligopolistic) industry, in order to raise prices andprofits.Overtime,theoptimalpriceandextractionpathfora resourcescartelwill bedescribedbyamodifiedHotelling arbitrage condition, whereby the marginalrevenue, rather than theprice,willgrowat the rateofinterest. This is because when extraction costs arenegligible,11thevalueforthemonopolistofextractingaunitofthecommoditysometimeinthefuturemustbethesameasthemoneythemonopolistwouldgetiftheyextracteditnowandkeptthemoneyinabank.

What thismeans is thatprices–andthusdepletion–will increase faster or slower than under perfectcompetition depending on the changes over time indemandresponsivenesstopricechanges(elasticityofdemand).Inparticular,economictheorysuggeststhatamonopoly will slow resource depletion when theelasticityofdemandincreaseswithpriceorovertime,and will accelerate resource depletion when theelasticityofdemanddecreases.Inshort,itwilldepleteresources at exactly the same rate as a perfectlycompetitive industry when the elasticity of demand isconstant (Dasgupta and Heal, 1979; Stiglitz, 1976;Lewis,1976).

Figure13representsthepriceandoutputpathwhentheresponsiveness of demand to price changes (i.e.the elasticity) increases over time. This is generallythought to be the more realistic case because as thepriceincreasesovertime,asubstitutefortheresourcemaybecomeavailable–andconsumerswillmorereadilyshiftawayfromtheconsumptionoftheinitialcommodity(DevarajanandFisher,1981;Teeceetal.,1993).Inthiscase, a monopoly cartel will deplete resources moreslowlythanaperfectlycompetitiveindustry(seeBox6foradiscussiononwhynaturalresourcesarepronetocartelization).Theintuitionisthat,knowingthatdemandelasticity will grow over time, a monopolist will takeadvantage of the chance of extracting higher rentstodaywhentheelasticityislowbylimitingextractionandcharginghighprices,thuspreservingresourceslonger.

Figure13:output and price paths in perfect competition and monopoly

Monopoly price

Time Time

OutputPrice

Monopoly output

Competitive output

Competitive price


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It is important toemphasize the limitationsofeconomictheory indescribingsomethingasstrategicallycomplexasdecisionsaboutexhaustibleresourceextractionunderimperfect competition. In an inter-temporal framework,decisions are made on the basis of expectations,especiallyabouttheactionsofotheragents.Assumptionsaboutthewayexpectationsareformulatedarethereforecrucial to determining the outcome. One commonassumptionisthatfuturepriceswillbe“announced”attheinitial date and that agents do not deviate from theannounced path. That is, producers set their extractionpaths and consumers their demand path given eachother’s strategic choice at the beginning of the period.This is equivalent to assuming the existence of well-functioningfuturemarkets.Intheirabsence,commitmentstoacertainpricepathwill,ingeneral,notbecredible,as

atsomelaterstagethebestchoiceofoneoftheparties,assumingthatallotherscontinuetobehaveaspredicted,may differ from the one envisaged at the initial date(Newbery,1981;Ulph,1982).12

(ii) Imperfect competition and trade in natural resources

The effects of trade opening on exhaustible naturalresources under imperfect competition remain largelyunexplored intheeconomic literature.This isbecausethe exhaustibility of natural resources and imperfectcompetition introduce dynamic and strategicconsiderations that significantly complicate welfarecomparisons.Theexistingliteraturedoes,however,helptorevealsomebroadpatterns.

Box6:Why are natural resources prone to cartelization?

The general case

Aproducercartelisaboutmonopolisticcoordinationaimedatjointlycuttingsupplyorraisingprice,thusleadingto increased revenue for the group. The conditions for cartel formation and cartel duration are not wellunderstood,buteconomictheorycanprovidesomeusefulinsights.Thereisaclearincentivetoformacartelwhenthegainsofsettingamonopolypriceexceedthecostsofimplementingandenforcingthecartelagreement.Thisismorelikelytohappenwhenthecartel’sshareofglobalsupplyishighandwhentheworlddemandaswellastheoutsiders’supplyofthecartelizedcommodityisnottoosensitivetopricechanges(Radetzki,2008).

Therearethreemajorproblemsthatacartelmustovercomeifitistobesuccessful.First,thereistheproblemofdeterminingtheoptimallevelofoutputandtherulesgoverningtheallocationofthatoutputamongcartelmembers.Thisisanissuesuppliersarelikelytodisagreeupon,astheydifferintechnology,discountratesandforecastsoffuturedemand.Similarly,whenacartelisformedamongcountries,thedifferinginterestspursuedbytheirgovernments,aswellasthedifferingsocialandpoliticalcontextsinwhichtheyoperate,mayreducethelikelihoodofstrikingadeal.

Second,onceoutputdecisionshavebeentaken,cartelmembershaveanincentivetorenegeontheagreementand sell additional output, thus reaping additional profits. The temptation to depart from the agreement ispositivelyaffectedbytheelasticityofdemand:ahigherresponsivenessofdemandtowhateverpricediscountisofferedbytheproducerisassociatedwithastrongertemptationtodefect.Inaddition,defectiondependsupon the probability of detection and punishment: the easier it is to detect deviations from commitmentsundertakenunderthecartel,thelesslikelyitisthatmemberswilldefect.

Third,acartelhastobeabletoprevententrybynewfirms.Highprofitswill, infact,provideanincentiveforotherfirmstoenterthemarket,andthiswoulddisruptthecartel’soriginalproductionandpricetargets.

The case of natural resources

Inthecaseofdepletablenaturalresources,differentforecastsabouttheamountofreservesandthestrategicvalueofsuchreservesmakeitparticularlydifficulttoreachanagreementonoutputandpricelevelsaswellasontermsofrevenuesharing.

There are, however, characteristics typical of natural resources that make the markets for these commoditiesparticularly prone to cartelization. First, natural resources tend to be concentrated in few countries, hence fewproducersgenerallyaccountforalargeproportionofworldsupply.Thisreducesnegotiationandenforcementcostsamongcartelmembersasthenumberofmembersrequiredtocoveralargeshareofworldsupplywillbesmall.

Second, natural resources tend to exhibit high fixed costs of extraction. These costs reduce the risk ofdissolution of a cartel due to entry by new firms, as they make it difficult for outside producers to equipthemselveswiththeproductioncapacitynecessarytoenterthemarket.

Third,naturalresourcestendtoberelativelyhomogeneous.Thisincreasestheincentiveforfirmstodefect,asahigher responsiveness topricechanges isassociatedwith lessdifferentiatedgoods.However,deviationsfromacartelagreementareeasiertodetectwhenproductsaresimilarthanwhentheyaredifferentiated(inthelattercaseitiseasiertocircumventtheagreementbyvaryingquality,forexample).


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Totheextentthatnaturalresourcesaregeographicallyconcentratedinonecountryorcontrolledbyacartel,itisclearthatthatcountryorcartelhasacomparative(aswell as an absolute) advantage in producing theresourceandwillexportit.Furthermore,intheabsenceofbarriers to trade, theextractionpathchosenby themonopolistwilldependonlyonhowthe inter-temporalworld(foreignplusdomestic)demandfortheresourcewill change over time. Therefore, the expectation thatimperfectcompetitionwilldeliveramoreconservativeexploitationpaththanperfectcompetitioncontinuestoholdtrue(Bergstrom,1982).

Asfaraspatternsoftradeunderimperfectcompetitionare concerned, economic theory suggests that thepredictionofthestandardHeckscher-Ohlintheorem–i.e. that countries will export goods using the factorwith which they are relatively better endowed – alsoholds true (Lahiri andOno,1995;Shimomura,1998).Thisexplainswhymineral-richcountriestendtoexportmineral products and import manufacturing-intensiveproductsfromcapital-richcountries.Itisworthnoting,however,thatinthecaseoffullycartelizedcommodities,the amount each country exports will depend on theproduction quotas agreed by the cartel’s members.Considerationsotherthancomparativeadvantagemayaffect decisions on quota allocation among cartelmembers, and thus trade patterns may depart fromcomparativeadvantageunderthesecircumstances.

Furthermore, imperfect competition may also help toexplain two-way trade (or intra-trade) in the samenaturalresource.13AccordingtoevidencebasedontheGrubel-Loyd index, this is relatively common for someresources(seeSectionB).Thestandardexplanationforsuchtwo-waytradeinagivenmarketisthatcountriesare trading different varieties of the same good(Krugman, 1979).14 This cannot be easily applied totrade in natural resources given the similar nature ofthese products. There are simply not that manyvariations of iron ore or copper, for example. Nor cantrade in natural resources within an industry beexplainedfullyintermsofdifferentiatedproducts–i.e.thetwo-wayexchangeofaresourceatdifferentstagesof the production process to exploit countries’comparativeadvantagesorincreasingreturnsofscale.This is because the cost of transporting bulkcommoditieslimitsthescopeforcreatinggeographicallyfragmented production chains. Indeed, many naturalresourcesarenotevensaleableuntilacertainamountofprocessinghasbeenundertaken.

Instead, an important explanation for intra-industrytrade in natural resource sectors may be theprevalenceofimperfectcompetitioninthesemarketsand the phenomenon of reciprocal dumping. Whenmarkets are sufficiently segmented, firms cansuccessfully price discriminate between foreign anddomestic markets, allowing them to charge a lowprice for exports in order to make additional sales(Brander and Krugman, 1983). The rationale is thefollowing:suppose that thesamenatural resource isproduced by a monopolist in each of two identicalcountries. If the monopolist firm in each country

charges the same price, no international trade willtake place. However, if the foreign and domesticmarketcanbesegmented,domesticresidentscannoteasily buy goods designated for export and eachmonopolist can price-discriminate – i.e. set a lowerpriceabroadthanathome.15

By selling into the foreign market, each firm makesadditionalsalesandprofits(eveniftheforeignpriceislower than the domestic price) and trade within anindustryresults.OnestudybyVasquezCordano(2006)explainsintra-industrytradeinliquefiedpetroleumgas(LPG)inPerubythepresenceofadominantgroupofrefinersthatfaceinternationalcompetitionandafringeofLPGimporters.Ifthedominantgroupofrefinersalsocontrols the supply of LPG in the country, and if it isabletochargehigherpricesathomethanabroad,thenthe competitive fringe will have to import LPG to beable to produce the refined product at a competitiveprice.

(d) Sustainability,technologyandtrade

Can an excessive use of exhaustible resources bycurrent generations affect the potential for futureeconomic growth? Will open trade facilitate or hindersustainable growth? The Brundtland Report on theEnvironmentandDevelopment(UnitedNations,1987)broadly defined sustainable growth as developmentthat “meets the needs of the present withoutcompromisingtheabilityoffuturegenerationstomeettheir ownneeds”. The focushere ismorenarrowlyontheeconomic forces thatmayoffset theexhaustibilityof finite resources and how they interact withinternationaltrade.

Fromtheeconomicperspective,thisdebatecentresonwhether theworldasawholecansustain thecurrentrateofoutputgrowthinthefaceofadecliningstockofnon-renewable resources that are essential to theproductionprocess.Recentpolicyandacademicworkhas emphasized that limits to growth arise, not onlybecause of the finite supply of natural resources, butalsobecauseof“nature’slimitedabilitytoactasasinkforhumanwaste”(TaylorandBrock,2005).Inthelattersense,sustainablegrowthdependsontheimpactthatthe by-products of economic activities (e.g. solidpollutants,toxicchemicals,CO2emissions)haveonthequalityoftheenvironment.Whilethetwointerpretationsof sustainable growth are related – in that theenvironment is itself a scarce natural resource – thefollowingdiscussion focusesmoreon resourcesupplylimitationsthanonenvironmentalconstraints.16

Many economists argue that the more pessimisticprognosesforthesustainabilityofeconomicgrowthfailto take into account adequately the forces that canoffsetnaturalresourcelimitations,namelytechnologicalchange and the substitution of man-made factors ofproduction (capital) for natural resources (Dasguptaand Heal, 1974). In particular, they have attempted toidentifytheconditionsunderwhichcapitalcanprovidean alternative to depleting exhaustible resources, and


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how technology can guarantee sustained productionandconsumptiongrowthovertime.Keytothediscussionis the issueofhow international tradeenters into thisprocess,andtowhatextentflowsofgoodsandservicesmaypromoteasustainablerateofeconomicgrowth.

Solow (1974a) shows that constant consumption canbesustainedbyasuitablepathofcapitalaccumulation,despitedecliningresourceflows.Thisispossibleonlyifthere is a certain degree of substitutability betweencapitalandanaturalresource,andifthelatterisanon-essential input.17 This intuition was translated into apolicyrulebyHartwick(1977),whoarguedthattherentderivedfromresourceextractionshouldbeinvestedinbuilding the capital stock (broadly defined to includeinfrastructure, physical capital, education) needed toguaranteeconstantconsumptionovertime.

There are also various ways in which technologicalchangecanhelp toaddressproblemsassociatedwithresource exhaustion. Resource-saving inventions canreduce natural resource requirements per unit of realoutput(Solow,1974b).Newtechnologycanalsohaveasubstitution effect, increasing the demand foralternative resources. For example, as the internalcombustionenginegraduallyeclipsedthesteamengineintheearly20thcentury,itgeneratedagrowingdemandfor oil which was effectively a resource substitute forcoal.Finally,improvedtechnologycanreduceextractioncosts or facilitate exploration, thus increasing theavailabilityofagivenresource.Considerthecaseofanon-renewable resource with escalating extractioncosts.Ifpricesrisetoohigh,demandwillbeextinguished,producing “economic exhaustion” even if some of theresource remains in the ground. However, the costincreasingeffectofdepletioncanbemorethanoffsetby thecost reducingeffectsofnew technologiesandthediscoveryofnewdeposits.

Two other considerations regarding technology andexhaustibility are relevant. First, technology caninfluence the eventual “exhaustibility” of a resource.Considerasituationinwhich,atcurrentconsumption,anon-renewableresourcewillbefullydepletedattimeT.Then, a new technology is introduced which eitherincreases resource supply (e.g. because of newdiscoveries, improved recycling methods), or reducesresource demand (through substitution or efficiencygains) – effectively postponing the point of depletionfromT to (T+n).Asa result, continuous technologicalchange shifts this depletion point indefinitely and anon-renewable resource begins to resemble arenewableresource.

Second,whiletechnologyisgenerallyseenasreducingthe problem of resource exhaustibility, the oppositeeffectcannotbeexcluded.For instance, technologiesthat increaseproductivity in theextracting sector canalso lead to an acceleration of resource exhaustion(CopelandandTaylor,2009).18

Alastpointthatshouldbehighlightedinanydiscussionoftechnologyandnon-renewableresourcesistheroleofinternationaltradeinfacilitatingthetransferofnew

technologies across national borders and in spurringresearch and development (R&D) activities amongcountries (World Trade Organization (WTO), 2008).Recentstudieshavefoundthattechnologicalspilloversaregreaterwithimportsfromhigh-knowledgecountries(Coe and Helpman, 1995) and that in developingcountriestotalfactorproductivityispositivelycorrelatedtotheR&Dactivityoftheirtradingpartners(Coeetal.,1997). This channel is termed “direct spillovers”.Countriesalsobenefitfrom“indirectspillovers”–i.e.theideathatacountrycanbenefitfromanothercountry’sknowledgeevenwhentheydonottradewitheachotherdirectlyaslongastheybothtradewithathirdcountry(Lumenga-Neso et al., 2005). Empirical evidencesuggests that what matters most is how muchknowledge a country can access – and absorb –through the totality of its global trade relations.Therefore, international trade can help guaranteesustained growth to the extent that it promotes thediffusionof technologies thatoffset theexhaustionofnaturalresources.

3. Tradetheoryandresourceexhaustibility:Theproblemofopenaccess

Theprevioussection lookedat the impactof tradeonfinitenaturalresources,andexaminedhowmarketscanhelptopromoteresourcemanagementandsustainableextraction and consumption. The following sectiondiscusses the specific problems related to “openaccess”–asituationwherecommonownershipof,andaccess to, a natural resource can lead to its over-exploitationandeventualexhaustion. Itexamineshowthis affects the pattern of international trade, factorprices and the gains from trade. Under certainconditions, the existence of poorly defined propertyrights (see Box 7 for a more detailed discussion ofproperty rights ineconomics)canresult in thenaturalresourceexportingcountrylosingfromfreetradesince,comparedwithautarky,freetradeleadstoapermanentreductioninitsstockofnaturalresources.

This apparently overturns the standard welfare resultfrom international trade theory which predicts thatcountriesgainfromfreertrade.Whilethisispossible,itisnottheonlyprobableoutcomeevenifthereisopenaccess to the natural resource. The reason for this isthatalotofotherthingscomeintoplay.Thestructureofdemand, population pressure, the technologicalcapacitytoharvesttheresourceandthestrengthoftheproperty rights regime interact in a complex way todetermine the final outcome. In particular, propertyrights are neither binary nor exogenous. Rather thanbeing completely perfect or completely absent, thestrength of property rights in a country falls along acontinuum.Propertyrightstonaturalresourcesmaybestrengthenedwithmoreopentrade,dependingonhowother elements that determine the definition andenforcementofpropertyrightsareaffected.19


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(a) Openaccessproblem

Open access refers to a situation where commonownershipof–andaccessto–anaturalresourcecanlead to its over-exploitation and eventual exhaustion.Consider the caseof a lake stockedwithfish that noone owns. In the absence of defined property rights,there will be too many fishermen on the lake. Thisdepletes the available stock of fish and reduces theefficiencyoftheefforttocatchfish.Thisisobviouslyaneconomic, as well as an environmental, problem. Thereason for this is that each fisherman on the lakereducestheproductivityofallotherfishermen.However,individual fishermen do not take into account thenegative impactof their activity on theproductivity ofotherfishermen. Ineffect, toomucheffort is spent tocatchtoofewfish.

Theresultoftoomuchentryisthatthetotalcatchfromthelakeisbarelyabletocoverthecostoftheefforttocatchthefish.Thedegreetowhichrent–thedifferencebetween total revenues from the catch and the totalcostincurredincatchingthefish-isdissipatedisthusameasureoftheinefficiencyintroducedbyuncontrolled

access (see Box 8 for estimates of the amount ofeconomic profits that could be generated from moreefficientmanagementofthenaturalresourcesstock).

This focus on economic efficiency is not inconsistentwiththeenvironmentaldesiretokeepthelakestockedwith fish. It could be argued that the economic andenvironmental interests coincide in this casebecauseasshallbeseen, theeconomist’spreferredsolution–strengthening of property rights over the naturalresource–rationsfishermen’saccesstothefishinthelake and reduces overfishing, producing an outcomethatisinlinewiththeenvironmentalist’sgoal.20

Since open access is such a significant feature ofcertain natural resources, this concept shall beexplained in greater detail. The renewable resourcegrowsataratethatdependspositivelyonthesizeofthecurrent stock.21 Given the ability of the resource toreplenishitself,itispossibleforhumanstoharvesttheresourceinawaythatthesizeofthepopulationremainsstationary. This “sustainable” harvest will be possibleonly if each period’s growth is harvested, leaving therest of the stock untouched. “Sustainable” here is

Box7:What are property rights?

Afullsetofpropertyrightsoveranassetentitlestheownerto:a)usetheassetinanymannerthattheownerwishesprovidedthatsuchusedoesnotinterferewithsomeoneelse’spropertyright;b)excludeothersfromtheuseoftheasset;c)deriveincomefromtheasset;d)selltheasset;ande)bequeaththeassettosomeoneoftheowner’schoice(Alstonetal.,2009).

Demsetz(1967)providesoneoftheearliesteconomicanalysesofpropertyrights,explainingwhyitarisesandthe characteristics of different property rights regimes. He argues that it is the presence of externalities,whether positive or negative, which explains why property rights arise. The assignment of property rightsallows economic agents to take these benefits or costs into account. The classic example he gives is thedevelopmentofpropertyrightsamongtheMontagnesIndiansinQuebecandthegrowthofthefurtradeinthelate 17th century. Before the development of the fur trade, there did not exist anything resembling privateownershipinlandamongtheMontagnesIndians.However,followingcommercializationofthefurtrade,therewasincreasingeconomicvalueinbeingabletohuntonlandonwhichfur-bearinganimalslived.Bytheearly18thcentury,theMontagnesIndianshaddevelopedacustomofappropriatingpiecesoflandforeachgrouptohuntexclusively.Thisfurtherdevelopedintoasystemofseasonalallotmentofland.

Theextremesofperfectpropertyrightsandofnopropertyrights(i.e.thetragedyofthecommons)(Hardin,1968)maybetheoreticallyusefulconceptsbutareunlikelytodescribereality.Thestrengthofthepropertyrightsregimeapplyingtoanaturalresourcemaybebetterdescribedaslyingalongacontinuum(i.e.aseriesofintermediatecases).Ostrom(1990),forexample,hasdocumentedthevarietyofinstitutionalarrangementsby which local communities have successfully managed common resources. These arrangements do notinvolvetheextremesofcompleteprivatizationnorfullgovernmentcontrol.CopelandandTaylor(2009)suggestthat one way to think of this continuum is in terms of the difficulty faced by a government or regulator tomonitorandenforcerulesonaccesstothenaturalresource.

Monitoringisimperfectsosomeunauthorizedharvestingoftheresourcewilltakeplace,butitwillbeeffectiveenoughtodetersuchbehaviourinmanyotherinstances.Alstonetal.(2009)takeadifferenttackbyfocusingonthequestionofwhoenforcespropertyrights.Theydistinguishbetweende jurepropertyrightswhichareenforced by the power of the state and de facto property rights which are enforced by the owner of theresourceorinalliancewithagroup,e.g.tribe,community,etc.Itisassumedthatthestatehasthecomparativeadvantageinenforcement,theindividualhastheleastadvantageandthegroup’sabilityliesinbetweenthetwo.Whetherthepropertyrightsregimeisdefactoorde juredependsonhowcrowdedthecommonsbecomefromencroachmentbyothers. If therearefewusersofthecommonresource,rentperuser ishighandtheindividualcandefendhispropertyrightsbyhimself.Butasencroachmentincreases,rentbecomesdissipatedand there are gains from banding together to try to exclude others from the resource or seeking de jureprotectionfromthestate.


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equivalent to what economists refer to as the steadystate equilibrium so the two terms shall be usedinterchangeably.22

The quantity harvested depends on the amount oflabour employed and on the size of the naturalresourcesstock.Themorefishthereareinalake,theeasier it will be to catch fish. Initially, as effort isincreased, so does the amount of the sustainableharvest.However,overtime,increasedeffortresultsin

theamountofsustainableharvesteventuallydeclining.The reason for this decline in productivity is thenegative relationshipbetweeneffortand thestockofthe natural resource arising from the steady statecondition.Thegreater theeffortput in, thesmaller isthe equilibrium stock of natural resources.23 Thesmallertheequilibriumstockoftheresource,themoredifficultitistoharvestorcatchagivenamountoftheresource.Eventually,theimpactofasmallerequilibriumstockoutweighstheimpactofadditionaleffort.

Box8:Rents and open access

Box5hasalreadyexplainedvariousdefinitionsofrent(differential,scarcityandquasi-rent)andhasclarifiedhowrentinthenaturalresourcessectorisbestconceivedasthesumofthedifferentialrent(whenproducingfirmsoperateunderdifferentconditions)andthescarcityrent,whichariseswhentherearerestrictionsonthesupply of a natural resource. In the case of natural resources suffering from open access, since it is notpossibletoexcludeothersfromusingtheresource,rentgoestozerobecauseeffectivelytheresourceisnotscarce.

Asdiscussedabove,thedegreetowhichrentisbeingdissipatedisanimportantindicatorofhowmuchopenaccessisreducingtheefficiencyofharvestinganaturalresource.Privateownershiporgovernmentownershipandregulationoftheresourcerepresentdifferentwaysoftryingtoaddresstheopenaccessproblem.Inbothinstances,accesstotheresourceisbeingrestrictedalthoughpossiblywithdifferentconsiderationsinmind.Inthecaseofprivateownership,andassumingthattheresourceownerhasazerodiscountrate,accesswillberestrictedsoastomaximizetherentthataccruestotheowner(seefullerdiscussionbelow). Inthecaseofgovernmentownership,therestrictionmaywellhavemaximizationofrentasanobjective,butitcouldalsohavesomeotherobjectiveinmind,e.g.biologicalorenvironmentalobjectivesuchasmaximumsustainableyield.

Onepopularmethodforcontrollingoverfishingistheuseofindividualtransferablequotas(ITQs)–permitstoharvestspecificquantitiesoffish.Thetotalallowablecatch(TAC)inafisheryisdeterminedbyaregulator,whomaydetermine this total foragivenyearon thebasisofeconomicorecological considerations.Generally,membersofthefisheryaregrantedpermitstoharvestashareoftheTAC.Sincethesepermitsaretransferable,thecurrentownercansellthepermittoabuyer,whowillthenacquiretherighttoharvestashareoftheTAC.Thesumoftheseshares,convertedintoquantitiesoffish,equalsthetotalallowablecatchsetbytheregulator.Ifthetotalcatchdeterminedbytheregulatorfallssignificantlybelowtheopenaccessoutcome,rentswillbegeneratedandtheITQswillreflectthepresentvalueofthestreamoffuturerents.Ifthetotalallowablecatchis not substantially lower than the open access outcome, the ITQs will not have any value (there is rentdissipation).

ITQshavebeenusedinanumberofOECDcountriesandinformationonthepricesofITQsareavailablefromstudiesthathaveexaminedtheseexperiences.PerhapsthemostdramaticexampleoftherentsgeneratedbymanagingfisheryresourcescomesfromIceland.Arnason(2008)estimatesthatbetween1997and2002,thevalueoffisheryITQsaveragedabout40percentofIceland’sGDPand20percentofthemarketvalueofitsphysicalcapital.OneoftheearlyadoptersoftheITQsystemwasNewZealand.Usingdatacoveringnearly15years, Newell et al. (2002) tested the arbitrage relationship between the rate of return on ITQs and otherfinancialassets.ThereasonfordoingthisisthatifITQswereeffectiveinstrumentsforfisheriesmanagement,theywouldbringarateofreturntoquotaownerscomparablewithotherfinancialassetsintheNewZealandeconomy.Thiswasindeedwhattheyfound:therateofreturnonITQswasclosetotheoverallmarketinterestrateinNewZealand.

Ifitisassumedthatthepriceofthenaturalresourceisunity (one), then the yield curve is also the revenuecurve, i.e. revenue=price timesyield (seeFigure14).The revenue curve shows how total revenue changeswiththeamountoflabourexertedtoharvestthenaturalresource. Suppose that the cost of harvesting thenaturalresourceislinearinefforti.e.C=c*E,wherecistheperunitcostofeffort.Therentorprofitearnedisequal tothedifferencebetweentherevenueandcostcurves,i.e.rentisequaltotheverticaldistancebetweentherevenuecurveandthelinearcost.

Withopenaccess,eachworkerwill try tocapture therentfromharvestingthenaturalresource.Therewillbeentryofworkersuntilthelastunitofeffortjustexhauststhe remaining rent.This takesplaceatE*where totalrevenue equals total cost. In contrast, if ownership ofthefishstockswereassignedtoasinglefisherman,andif he did not discount the future, he would have aninterestinmaximizingthesustainablerentthatcouldbeearned from his ownership of the resource. Thefisherman would limit access to the lake’s fish stocksandwouldallowotherfishermentoexpendeffortonly


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(b) Patternsoftrade

Whatistheimpactofinternationaltradeonopenaccessnatural resources?To illustrate theprinciplesatwork,imagine two countries that have equal amounts of anatural resource, the same technologiesand identicaltastes,butdifferwithrespecttopropertyrights.Accessto the stock of the natural resource is perfectlycontrolledinthefirstcountry,butthereisopenaccesstothenaturalresourceinthesecondcountry.Inautarky,itcanbesupposedthatthesecondcountrywillharvesta larger quantity of the natural resource – and at arelatively lower price – than the first country. Whentradeisopenedup,thesecondcountrywillthenexportthenaturalresourcetothefirstcountry.

In standard trade theory, countries that have identicaltastes,endowmentsandtechnologieshavenoreasontotrade.However, introducingdifferences inthestrengthofeachcountry’sproperty rightscreates thebasis fortrade despite the countries being identical in all otherrespects.Thismeansthatapropertyrightsregimecanserveasade factobasisofcomparativeadvantage–aconclusionthatissupportedbytheeconomicliteratureonthesubject–(Chichilnisky,1994;BranderandTaylor1997;BranderandTaylor,1998;Karpetal.,2000).

Nowsupposethatthecountriesalsodifferinthesizeoftheirnatural resourcestocks,andthat it is thecountrywith strong property rights that has relatively moreabundant stocks. One would have assumed that free

until marginal revenue equalled marginal cost. ThiswouldbeatthelevelE**wheretheslopeoftherevenuecurveequalstheslopeofthecostlineandsustainablerent is at a maximum. At this economically efficientpoint,theequilibriumstockwillbelargerthanthestockcorresponding to open access. An alternative way tointerpret the level of effortE** is that itwouldbe theallocationofeffortinthenaturalresourcessectorthatwouldhavebeenchosenbyaregulatorwhoseobjectiveistomaximizesocialwelfare.

On the other hand, if the owner of the fish stockdiscounts future revenues, he would choose a steadystatestockthatislowerthanthatwhichmaximizesrent.HecanachievethisbyallowinggreaterfishingthanE**,reducing the existing fish stock, but yielding himadditional revenues.Thisadditional revenuewill comeattheexpenseoflowerfuturerentsbecausethesteadystate stock will be lower. But a positive discount ratemeans this reduction in future rent is valued less,providing the incentive for the resource owner toharvestmoreoftheexistingstock.Asthediscountrategoestoinfinity,theownerwillharvesteverythingtodayeven if it means the resource is extinguished. This isbecause an infinite discount rate means the resourceownerattachesnovalueatalltofuturerevenues.24

Althoughthesimplemodelservesasausefulillustrationof the problems related to open access resources, inthe real world the management of such resources istypicallyfarmorecomplex.Forexample,manyfisheriesoperateundervariousgovernment-imposedregulations,such as gear limitations, area closures, or length-of-season restrictions. This had led some economists todevelop an alternative framework, “regulated openaccess”, for analysing resource systems whereauthorities are able to effectively enforce regulationsbutwhereotherwisethereisfreeentrybyfishermensothat rents are fully dissipated (Homans and Wilen,1997). The system lies somewhere between openaccess, at one extreme, and rent-maximization, at theother. It may well be that most fisheries in developedcountriesfallwithinthisintermediatecategory.Sinceitisassumedthattheregulationiseffective,thestockofthe natural resource will be greater in long runequilibriumunderthissystemthan intheopenaccesscase,andconsequently, thequantityoffishharvestedwill be greater since the fishery is more productive.SimulationsbyHomansandWilen(1997)fortheNorthPacific Halibut fishery25 – which they consider anexampleofaregulatedopenaccesssystem–suggestthatthedifferenceinstockandharvestlevelsoverthepureopenaccessmodelcanbedramatic.

Figure14:open access and optimal harvest of natural resources

A

Dollars

Labour effort

E* – open access level of effortE** – level of effort that maximizes rentAB – rent

Revenue

Total cost

B

E** E*


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trade would result in the natural resource-abundantcountry exporting that good to the natural resource-scarce country. However, the relative strength of thecountries’propertyrightsregimesexertsanindependentinfluenceoncomparativeadvantageandhenceon thepatternof trade. It ispossible for thecountrywhich islessabundantinthenaturalresourcetoendupexportingthat good to the natural resource abundant country iftheformer’spropertyrightsregimeissufficientlyweak.

Ofcourse,otherthingshavetobetakenintoaccount.Inparticular,predictionsabout thepatternsof tradealsodepend on the structure of demand. Building on thework of Brander and Taylor, Emami and Johnston(2000)showthatifthedemandforthenaturalresourceis relatively high, then the country with the weakproperty rights can end up importing rather thanexportingthenaturalresource(seeBox9).Thiscanbeexplainedas follows: thecombinationofhighdemandfortheresourcegoodandpoorpropertyrightsleadstomassivedepletionof thestock,even inautarky,andasmallharvest.Thus, if trade isopenedup, thecountrywithpoorpropertyrightswillrapidlydepleteitsresourcestockandendupimportingthegood.

(c) Gainsfromtrade

Whenanaturalresourcesectorsuffersfromopenaccessor common pool problems, in principle the basic “gainsfrom trade” result is undermined. While the long-run(steadystate)welfareoftheresource-importingcountryrises with trade, it declines for the resource-exportingcountry.Intuitively,thisisbecausefreetradeexacerbatestheexploitationofthenaturalresourcesothatthesteady

statestockislowerthaninautarky(BranderandTaylor,1998).Sincethesizeofthenaturalresourcestockaffectslabourproductivity, the lower steady state stockmeansthattheeconomywillbeharvestingasmallerquantityofthenaturalresourcegoodunderfreetrade.Analternativewayofunderstandingwhythesizeofthenaturalresourcestockaffectswelfareisthatitrepresentscapital(inthiscase,naturalcapital)fromwhichtheeconomycanearnastream of future returns. The smaller the stock of thenatural resource, thesmaller futureharvestswillbe.Anexampleofhowthecombinationofopentradeandweakpropertyrightscanleadtothenearextinctionofanaturalresourceandawelfare lossfor theexporter is the19thcentury slaughter of the Great Plains buffalo (Taylor,2007).

However, introducing additional features to thissimplifiedmodelcanproduceaverydifferentresult. Ifthedemandforanaturalresourceisrelativelyhigh,thestandardgains from tradewill result (seeBox9), andfreetradewill increasethewelfareofboththenaturalresourceimportingandexportingcountries(EmamiandJohnston,2000).Asexplainedearlier,withhighdemandfor the natural resource, the country with strongproperty rights exports the natural resource to thecountrywithweakpropertyrights.Thisimpliesthatthelong-run stock of the natural resource in the countrywithpoorpropertyrightswillactuallybehigherthaninautarkyandsoleadtoawelfaregain.Thewelfareofthecountrywithstrongpropertyrightsalsorisessince itsnatural resource sector is being optimally managed(priceequalsmarginalcost).Inotherwords,eveninthecaseofopenaccessresources,freetradecanincreasethewelfareofbothcountries.

Box9:the role of demand

To better explain the role of demand, an example of two countries that produce manufactured goods andharvestanaturalresourcewithlabourisconsidered.Theonlydifferencebetweenthesetwocountriesistheirpropertyrightsregimes.Thestructureofdemandisidenticalinbothcountries.Weshallexaminetheresultingpatternof tradewhen theymove fromautarky to free trade.The resultdemonstrates thateven though thepropertyrightsregimeiscriticalindeterminingthepatternoftradeandwhethertherearewelfaregainsfromtrade,theintensityofdemandforthenaturalresourcecandramaticallyaltertheresults.

Onecountryhassuchweakpropertyrightsthatitsuffersfromopenaccess.Underopenaccess,therelativesupplycurve(Sw)fortheresourceisbackwardbending,whichmeansthatasthepriceofthenaturalresourcerises,theamountofharvestdeclines.Thereasonforthisunconventionalshapeofthesupplycurveisthatasthepriceofthenaturalresourcerises,morelabourisdrawntothesector.Thisincreaseineffortreducesthestockofthenaturalresource,leadingtoadeclineintheproductivityofworkers.Ifthepricerisessufficientlyhighenough,thelossinproductivitycanleadtoadecreaseinsteadofanincreaseintotalharvest,despitethegreateramountoflabourbeingusedinthesector.

Forthecountrywithstrongpropertyrights,therelativesupplycurvefortheresourcewillhavetheconventionalshape–itispositivelysloped(Ss).Itcorrespondstothemarginalcostcurveofharvestingtheresource.Thisisbecausetheresourceowner(ortheregulator)allowsharvestingofthenaturalresourceonlyuptothepointwheremarginalrevenueequalsmarginalcost. Ineffect,theexternalityposedbytheindividualharvestertoothers(hisharvestingdecreasestheopportunityofotherstocatchmore)isinternalizedbythesingleresourceownerortheregulator.Inresourcesystemswithopenaccess,thesupplycurveincontrastcorrespondstotheaveragecostcurvesinceeffortinharvestingcontinuesuntiltotalrevenueequalstotalcost.

Whathappenswhenboth thesecountriesopenup to trade?Twoscenarioscanarise. In thefirst scenario,relativedemandfortheresourceislow,sothedemandcurveintersectstheupwardslopingpartofboththesecountries’supplycurves.Intheotherscenario,demandfortheresourceishigh,sotherelativedemandcurveintersectsthebackwardbendingpartofthesupplycurveofthecountrywithweakpropertyrights.Thepatternandthebenefitsfromtradewilldifferdependingonthesituation.


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Relativedemandfortheresourceislow(seeFigureA)

Relativedemand inboth countries isgivenbyDL. In this case, theautarkypriceof the countrywithweakproperty rights isgivenbyPwwithproductionatOE.Theautarkypriceof thecountrywithstrongpropertyrightsisgivenbyPswithproductionatOB.Whentradeisopenedup,thefreetradepriceP*willsettlebetweenthe twoautarkyprices.Thecountrywithweakproperty rightswillexport thenatural resource to theothercountry,depletingthestockofitsresource.Itsexport(CF)isgivenbythehorizontaldistanceattheworldpricebetweenthedemandcurveanditssupplycurve.Correspondingly,theimport(AC)ofthecountrywithstrongpropertyrightsisequaltothedistancebetweenthedemandcurveanditssupplycurve.Asaconsequenceofthispatternoftrade,thecountrywithpoorpropertyrightswillhavealowersteadystatenaturalresourcestockandsufferfromawelfareloss.Thecountrywithstrongpropertyrightswillreapthestandardgainsfromtradesinceitsuffersfromnodomesticdistortion.

FigureA:Free trade when relative demand for a natural resource is low

A BO C E F

SW SS

DL

P* – world price

AC – imports ofnatural resourcegood by countrywith strong property rights

CF – exports ofnatural resourcegood by countrywith weak property rights

Harvest/Manufactures

Relativeprice

PS

PW

P*

Relativedemandfortheresourceishigh(seeFigureB)

Ifinautarkythereisahighrelativedemandforthenaturalresource(DH)inbothcountries,thecountrywithlittle or no property rights will be operating in the backward bending portion of its supply curve, with theaveragecostofharvestingtheresourcebeingveryhigh.Highdemandleadstoalotoflabourbeingdevotedtothe natural resource sector, causing the stock to run very low. Since the size of the stock affects labourproductivity,harvestwillbelowinthecountrywithpoorpropertyrights.TheautarkypriceofthecountrywithweakpropertyrightswillbePwandproductionwillbeatOA.Inthecountrywithstrongpropertyrights,theautarkypriceisatPsandproductionatOE.Whentradeisopenedup,thecountrywithstrongpropertyrightsendsupexportingthenaturalresource(equaltoCF)tothecountrywithpoorpropertyrights.Thecountrywithstrongpropertyrightswillreapthestandardgainsfromtradesinceitsuffersfromnodomesticdistortioninthefirstplace.Thefreetradestockofnaturalresourceswillbehigherinthecountrywithpoorpropertyrightsthanunderautarkyanditwillalsogainfromtrade.

FigureB:Free trade when relative demand for a natural resource is high

SWSS

DH

P* – world price

BC – imports ofnatural resourcegood by countrywith weak propertyrights

CF – exports ofnatural resourcegood by countrywith strong propertyrights

A BO C E F Harvest/Manufactures

Relativeprice

PS

PW

P*


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(d) Factorprices

AccordingtotheHeckscher-Ohlintheory,internationaltradeleadstofactorpriceequalization.Inotherwords,trade in goods substitutes for the movement of thefactors of production. In the literature on trade inrenewable natural resources, the only factors ofproductionarelabourandthestockofnaturalresources.Inalmostallcases,therealwageoflabouristhesameacrosscountries.

However, factorprices in thenatural resourcessectorwillnotbeequalized.Takethesimplestexamplewherecountriesdifferonlyinpropertyrights.Inautarky,therewill be rents from optimally using the resource in thecountrywithstrongpropertyrights,whereastherentswill be driven down to zero in the country withoutpropertyrights.Withfreetrade,rentswillcontinuetobezerointhecountrywithopenaccesswhetheritendsupimportingorexportingthenaturalresource.Ifitstradepartnerhasstrongerpropertyrights,rentswillcontinuetobeearnedunderfreetrade.Theresultobtainedhere– factor prices are not equalized by trade – should,perhaps,notcomeasasurprisegiventheexistenceofamarketfailure.

(e) Howtradeaffectspropertyrights

Whataboutthecasewherethepropertyrightsregimeisendogenous– i.e.where theabilityofgovernments toenforcepropertyrightsisaffectedbytradeopeningandrelativeprices(CopelandandTaylor,2009)?Theanswerto this question is a mixed one. The strength of apropertyrightsregimedependsonavarietyoffactors,includingtheabilitytomonitorandpreventcheating;thecapacity to extract or harvest a resource; and theeconomicincentivetodepletearesource.Anincreaseinresourcepricesasaresultoffreetradecanaffecteachofthesefactorsindifferentways.Forexample,ahigherprice could increase incentives to extract more of aresource, but it could also reduce incentives to poachtheresourceifthepenaltyistoloseaccesstothenowmore valuable resource forever. Higher prices couldencourage investments in resource extraction, but itcould also enhance regulatory capacity, thus assistingthetransitiontomoreeffectiveresourcemanagement.

Theendogeneityof theproperty rights regimemeansthat there could be a variety of outcomes from tradeopening. In particular, resource-exporting countriescouldgainfromfreetrade.Forsomeeconomies,wheretheautarkicpriceoftheresourcewaslowtostartwith,theincreaseinrelativepricearisingfromfreetradecanlead to a transition to more effective management.Theseeconomieshaveenoughenforcementcapabilitysothatrentsaregeneratedatasufficientlyhighpriceforthenaturalresource.However,forsomeeconomies,it remainstruethat themovetofreetradewill leadtoresource depletion and real welfare losses. Theseeconomiesarethosewherethenaturalresourceisslowto replenish itself, where economic agents have astrong preference for current consumption, over-harvesting is hard to detect, harvesting technology is

moreproductive,andwherea largenumberofagentshaveaccesstotheresource.

Highlightingthevarietyofpossibleoutcomes,Copelandand Taylor (2009) offer several examples where theopening of trade opportunities sometimes facilitatedbettermanagementofnaturalresourcesandothertimesled to over-exploitation. Oneexample of success is thegeoduck26fisheryinBritishColumbia,whichwasinitiallyopen access but became a well-managed fishery withindividualharvestquotasprimarily inresponsetoexportdemand from Asia. One example of over-exploitation isthe North American buffalo that was discussed earlier.AnotherexampletheyciteistheopeningoftheEstoniancoastal fishery to exporting in the 1990s, whichcontributedtotherapiddepletionoffishstocks.

(f) Changesinpopulationandtechnology

Doespopulationgrowthleadautomaticallytoincreasedpressure to circumvent property rights and exploitnatural resources? A study of forest cover in India byFoster and Rosenzweig (2003) provides empiricalevidence that population and economic growth can,undercertaincircumstances,actuallyencouragebetterresource management. Population growth has twocontradictory effects: on the one hand, it raisesharvesting capacity, which in turn makes it easier todepleteagivenresource.Ontheotherhand,itincreasesthedomesticpriceofresourceproducts,duetogrowthindemand,generatingrentsinthatsectorandreinforcingincentivestobetterregulateandmanagetheresource.

The key question is whether growing demand for theresource increases its price sufficiently to offset theincreased capacity to harvest the resource. If thecountryexperiencingpopulationgrowthissmallrelativeto global markets and cannot influence the worldresourceprice,thenthenegativerelationshipbetweenpopulationsizeandresourcestockwillhold.However,ifthecountryislargerelativetotheworldeconomy–sothatthepopulationincreasetriggersariseinthepriceof the natural resource – it is possible for resourcemanagementtoimprove.

Similarly,technologicalimprovementscanhaveamixedimpactonpropertyrightsenforcementandthedepletionof natural resources. For example, improvements insurveillancetechnologycanassistfishermentobetterdetect the location of fish, thereby putting morepressure on the resource; but they can also helpregulatorstobetterdetectillegalfishing,whichleadstobetterresourcemanagement.

4. Naturalresourcesandtheproblemofenvironmentalexternalities

Sofar,twokindsofnegativeeffectshavebeenanalysedin the context of exhaustible resources. The first isstrictlyrelatedtothefactthatsomenaturalresourcesarefinite.Insuchasituation,ifeitheraproducingfirmor


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asocialplannerdoesnot take this issue intoaccountwhendecidinghowmuchtoextracttoday,consumptionlevelsabovethesocialoptimuminthepresentwillimplyless consumption for future generations. The secondeffect is related to the open access problem ofexhaustibleresources,wherebythecollectiveownershipofaresourcemightresultinitsoveruseanddepletion.

The use of exhaustible resources in production andconsumptionactivitiesleadstoathirdkindofnegativeeffect that manifests itself through changes to theenvironment.Inthecaseoffossilfuels,forinstance,oilor coal extraction causes acidification of the sea andproduces atmospheric CO2. In the case of forestry,excessive timber extraction leads to loss of naturalhabitat for plant and animal species due to decliningsoilfertilityandchangesinclimateandbiogeochemicalcycles.Finally, inthecaseoffisheries,over-harvestingone species might have a negative impact on otherspeciesandhenceonbiodiversity.

Thisthirdtypeofeffect–whicheconomistsdefineasenvironmental externalities– is the focusof this sub-section.Anexternalityofaneconomicactivityreferstoitsimpactonapartythatisnotdirectlyinvolvedinsuchactivity.Inthiscase,pricesdonotreflectthefullcostsorbenefitsinproductionorconsumptionofaproductorservice. An example of environmental externalities isthefactthatoilproducersmaynottakeintoaccountthefull costs that theextractionanduseof this resourceimposes (on future, as well as present, generations)throughpollution.This implies that thepriceofoilwillnotreflectitsenvironmentalimpact.Killingdolphinsasa by-product of catching tuna is another example ofenvironmental externalities. In this case, the marketpriceof tunadoesnot take intoaccount thenegativeeffectofthetunafisheryonbiodiversity.

This sub-section discusses the characteristics andtypes of environmental externalities generated by theextraction and use of exhaustible resources. Theeffects of trade on the environment will also beillustrated taking into account the interaction thatenvironmental effects have with the other types ofexternalitiespreviouslydiscussedinthisreport.27

(a) Fossilfuels,pollutionandtrade

To understand the effects of the use of energyresources on the environment, it is useful to classifyenvironmental externalities into two categories: flowand stock externalities.28 Flow externalities representthe environmental damage caused by the currentextractionoruseof the resource.Anexampleofflowexternalities is air pollution generated by the use ofenergy in oil extraction or mining. Stock externalitiesarise when environmental damage is a function ofcumulative emissions. Examples of stock externalitiesincludetheatmosphericaccumulationofcarbondioxideand its effect on the global climate, contamination ofground water from oil or coal extraction that is onlyslowly reversed by natural processes, and irreversibledamagetonaturallandscapesthroughstripmining.

A general conclusion of existing studies29 onenvironmentalexternalitiesisthatpostponingresourceextractiontoday–andthusreducingpollutingemissions– isoptimal. In thecaseofflowexternalities, the factthat resources are exhaustible partially offsets theproblem. Following the Hotelling rule,30 a pattern ofrisingpricesreflecting the increasingscarcityoffinitefossil fuels implicitly addresses part or all of theenvironmentaldamagegeneratedby theextractionofsuch resources. In addition, the market may react toprice increases by developing alternative energytechnologies which can also help to address theenvironmentaldamagecausedbythecurrentextractionoruseoftheresource.

Inthecaseofstockexternalities,themarket-determinedrateofdepletionistoohigh.StudiessuchasBabuetal.(1997) show that a modified Hotelling rule, whichincorporates costs related to damage flowing fromaccumulating pollution stocks, would slow downextraction today and hence would ensure a socialoptimum. While under the original Hotelling rule, anadditionalunitofresourcewillbeconservedonlyiftheresourcepricerisesataratefasterthanthemarketrateof interest, under this new modified framework, anadditionalunitofresourcewouldbeconservedevenifthe equilibrium resource price rises at a slower pacethantheinterestrate.Thiscomesfromthefactthatanincrease in the consumption of resources today willincrease the pollution stock tomorrow. In eachsubsequentperiod therewillbeanadditionaldisutility(i.e. welfare loss) caused by higher pollution stockcreatedinearlierperiods.Inthesecases,anadditionalunit of resource would be conserved in the currentperiodtopreventhigherdisutilityinfutureperiodsevenif the resource price is rising more slowly than themarketrateofinterest.

What is the relationship between trade in fossil fuelsandenvironmentalexternalities?Thisquestionispartlyansweredbyaseriesofmodelsinwhichthepresenceoftradeacrosscountriesisimplicitlytakenintoaccount.In these studies, it is assumed that resources areconsumedbyallcountries,bothexportersandimporters–arealisticassumptiongiventhatmostnon-renewableenergy resources are unevenly distributedgeographically (see Section B.1) and the globaleconomyishighlydependentonfossilfuels.31Therefore,ifthedemandofnon-producercountriescoincideswiththeir imports, the relationship between trade andenvironmental externalities will depend on a series offactors,discussedbelow,directlyaffectingtheoptimalrateofextractionoruseoftheresources.

Some of these factors may accelerate resourceconsumption compared with the social optimum andexacerbate the negative impact on the environmentrelateddirectlytotheextractionanduseoffossilfuels.First, the presence of asymmetric information onresourceavailabilitycanencouragebothexportersandimporters to behave strategically. For example,importers might have an incentive to announce thedevelopment of a backstop technology32 to increasetheir bargaining power and to drive down resource


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costs,whileexportersmightbetemptedtoexaggerateexisting resource stocks in order to delay thedevelopment of substitutes.33 In both situations, theextraction rateof the resourcewill be faster than thesocial optimal rate, and environmental damage willincrease. In the first case, exporters will react to thethreatofabackstoptechnologybyraisingtheextractionrate and lowering the resource price. In the secondcase,exporterswillfollowafasterextractionpaththatisconsistentwiththeover-estimatedresourcestock,inorder to lend credibility to their exaggerated claimsabouttheextentofresourcereserves.

Second, cost-reducing technologies tend to have anegative impactonresourceprices,bydecreasingthemarginalcostsofresourceextraction.Theoveralleffectontherateofextractionoftheresourcesandhenceonenvironmental damage will depend on the trade-offbetween technological progress and resourceexhaustibility.StudiesbyAndréandSmulders (2004),Farzin (1992) and Krautkraemer (1985) show that, intheshortrun,decreasingcostsduetoatechnologicaladvance tend to off-set increasing costs due to therisinginsituvalueoftheresource.Pricedecreaseswillleadtohigherconsumption,andthusmorepollution.Inthe longrun,however, therisingvalueof theresourcestillinthegroundwilloutweighthedecreasingcostsofextraction, so prices will rise again. The pollutiongeneratedintheshortrunwillpersistovertime,soevenif the rate of resource extraction decreases in thefuture,thenegativeeffectontheenvironmentremains.

Third, the discovery of new resources can have aneffect similar to that of cost-reducing technologies.34Becausenewdiscoveriesgenerallymeanthatresourceextractionbecomeseasierandcheaper,pricesdeclineandconsumptionincreases–withnegativeeffectsontheenvironment. In the long run, however, explorationopportunities will run into diminishing returns andresourcepriceswill riseagain.35 Theoverall effect ontheenvironmentwilldependonhowlongtheadditionalpollutiongeneratedovertheshorttermremains.

Lastly, as already discussed in Section C.4, propertyrights incertainnaturalresourcesectorsarenotwell-defined or protected. Consider a situation in whichconcessionrightstoexploitaresourcearegrantedbyagovernment that iseithercorruptorweak.Facedwithpoliticaluncertainty,resourceownershaveanincentiveto speed up resource extraction above the socialoptimumlevel inorderto lockinprofits–whichwill inturnbedetrimentaltotheenvironment.

Ontheotherhand,newtechnologiescanalsohelp tolimit thenegative impacton theenvironment–as, forexample, when carbon-reducing technology limits theCO2 generated by resource extraction (Welsh andStähler,1990;Tahvonen,1997;Grimaudetal.,2009).Inotherwords,ifanabatementtechnologyexists,andifits cost is sufficiently low, then the optimal rate ofresource extraction speeds up and environmentalconstraints are partially loosened – reducing thesacrifice of the current generation. In addition, if theabatement technology helps to reduce the impact on

theenvironmentcausedbycumulativeemissions,thenin the long run total emissions will also decrease. Anabatement technology can be thought as a “cleaner”waytoextractpollutingresources.36

Therolefortradeinthisprocessisworthhighlighting.When energy resources are highly substitutable andwhentheirpollutioncontentcanbeclearlydifferentiated,trademighthelptomitigatesomeoftheenvironmentalexternalitiesderivingfromfossilfueluse.Forexample,countriesusingoil or coal as their principal sourceofenergy could switch to imports of natural gas – the“cleanest” fossil fuel in terms of carbon dioxideemissions37 – thereby slowing the accumulation ofpollutantsanddoinglessharmtotheenvironment.

(b) Renewables,biodiversityandtrade

Environmentalexternalitiescanalsobetheby-productsofharvestingnaturalresourcessuchasfishandforests.Thefollowingdiscussionfocusesoneffectsoftradeinexhaustibleresourcesonbiodiversity.

(i) Habitat destruction and trade

Becausetimberoragriculturalproductionrequirestheuseofland,habitatdestructioncanbeadirectresultofthe expansion of such economic activities. Habitatdestruction is a major cause of declining numbers ofspecies–orreducedbiodiversity–becauseitintensifiesthe competition among species for basic resourcessuchasfoodandwaterandmakestheirsurvivalmoredifficult.38Differentstudies39haveanalysedtheeffectsof trade on production patterns across countries, onhabitat destruction and on biodiversity. The generalconclusionisthattheclassicalgainsfromtradeopeningmaynolongerhold,oncethenegativeimpactrelatedtodecliningbiodiversityistakenintoaccount.40

Tounderstandtheeffectsoftradeinnaturalresourcesonbiodiversity,considertwoidenticalcountries,ahomecountry and a foreign country, which have the samefixedamountoftwotypesofnaturalhabitat,forestandgrassland (Polasky et al., 2004). The number ofdifferent incumbentspecies represents theecologicalproductivity of each type of habitat. In addition, anincreaseinthesizeofthehabitatwillraisethenumberof species. However, marginal ecological productivitydecreaseswithrespecttohabitatsize.41Inotherwords,thebiggertheexistenthabitatthesmallerthenumberof extra species that will be produced by a marginalincreaseinitssize.

Intheabsenceoftrade,bothcountriesproducetimberandgrain.Fortheproductionoftimber,forestlandhasto be converted, whereas the production of grainrequires the conversion of grassland. Once land isconverted to productive use, it can no longer supportnative biological species. If the home country has acomparative advantage in producing timber and theforeign country in producing grain, then opening totrade will lead to an equilibrium in which the homecountry specializes in the production of timber and


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importsgrain.Theoppositewillhappen inthecaseofthe foreign country. In addition, full specialization ofproduction will lead to full specialization in naturalhabitatconservation.Inthehomecountry,forinstance,specializationintimberproductionwillmakethecountryspecialize in the conservation of grassland at theexpense of forests. What then is the impact of tradeopeningonthecountries’biodiversity?

Theeffectof tradeonbiodiversitywilldependon therelationship between the ecological productivities ofeachhabitat.Tobetterunderstandthisresult,considerFigure15wheretheproductivityinproducingspeciesof grassland relative to ecological productivity offorestland(d)inthehomecountryisrepresentedinthehorizontalaxis.LinesAandBillustraterespectivelythelocal biodiversity of the domestic country in autarkyandinfreetrade.Thesetwolinescrosseachotherat

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˜ d > 1 because the marginal ecological production ofeachhabitatispositivebutdecreasinginlandsize.

If both forest and grassland habitat have the sameecological productivity (

€

d = 1) and the home countrystarts specializing in the production of timber, thenegativeimpactderivingfromareductioninforestlandwill be greater than the benefit of an increase ingrassland.Tradeintimberproductionwillhaveapositiveimpact on the home country’s biodiversity only if theecological productivity of grassland relative toforestland issufficientlylarge(

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d > ˜ d )tooffsethabitatdamagecausedbyadecreaseinforestland.

Theimpactoftradeopeningonglobalbiodiversitywilldependonthedegreetowhichspeciesarespecifictoa certain country.42 More precisely, if each species isspecific to each country, the effects of trade onaggregate biodiversity will coincide with those ofcountry-specific biodiversity. If, however, prior toopening up to trade the same species live in allcountries,tradecanbebeneficialevenifbothcountrieshavethesameecologicalproductivity.Inthislastcase,tradeopeningwill leadtoa localdeclineofspecies inthespecializingsectorbutalsotoanincreaseofspecies

intheimportingsector.Sinceeachcountryspecializesin a different product, the overlap of species will bereduced(speciesthatexistedinmultiplecountriesexistnowinonlyonecountry),butworldwidebiodiversitywillincrease.43

(ii) Open access, biological interaction across species and trade

Studieslookingattherelationshipbetweentrade,openaccess problems and biodiversity typically focus onfisheries.44 They suggest that outcomes depend to asignificant extent on the nature of the biologicalrelationshipbetweenthetradedspecies(seeTable6).Theserelationshipscanbeclassifiedintothefollowingthreetypes:apositiveorsymbioticrelationship(wherethestocksofthetwospeciesaremutuallybeneficial);anegative relationship (where the stockof one species[e.g.,fishparasites]reducestheproductivityorsurvivalpossibilities of another species); and an asymmetricrelationship(wherethefirstspeciesservesaspreyforthesecondspecies).

Considerasituationinwhichthereisnotradebetweentwo countries and there is a trans-boundary commonpoolproblem,asbothcountriesfishinthesamewater(Fischer and Mirman, 1996). In addition, assume thatbothcountriescatchandconsumetwotypesofspecies–andhenceareconcernedaboutthebiologicalcross-effectsbetweenthem.Underthisscenario,theproblemof over-harvesting will be mitigated if the biologicalrelationship across species is positive and the rate ofreproduction of one species is higher than the cross-effectbetween the twospecies.Sinceharvesting thefirstspecieswillreducethestockandhence,thetotalconsumptionofthesecondone,thenanoptimalsolutionwillbetoreducethetotalharvestingofthefirstspecies.When the biological relationship between species isnegative,theproblemofover-harvestingismoreacute.Moreprecisely,thefactthatareductioninonespeciesimplies an increase in the stock of the other speciesitselfleadstoover-harvesting.Finally,intheasymmetriccase, there will be even greater harvesting of the

Figure15:Biodiversity, ecological productivity and trade

A(Autarky)

Biodiversity decreases with trade

Biodiversity increases with trade

~d d

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predator fish while over-harvesting of its prey will bereduced.

Considernowasituationinwhichthetwocountriescantradeandeachof themspecializes incatchingoneofthespeciesand imports theother (DattaandMirman,1999).Ifcountriestakeinternationalpricesasgiven,45thefactthatacountryisdepletingitsownresourcewillnot be reflected in the other resource’s price. Moreprecisely, agents will not care about the biologicalcross-effect they will produce when harvesting andtherefore, in the presence of a positive biologicalrelationship between species, countries will harvestmorethanwhatwouldbegloballyoptimal.Incontrast,ifthebiologicalrelationshipbetweenspeciesisnegative,there will be under-harvesting. In this case, bothcountries could harvest more because a reduction inonespeciesisbeneficialfortheotherandviceversa.

As the number of countries exploiting each speciesrises and trade increases, there is no clear cutconclusion as to whether the common pool problemworsens or lessens in the presence of biologicalinteractions across species. Whether there is over- orunder-harvesting will depend on a variety of factorssuch as the number of countries, the price effect,consumer preferences and the type of biologicalrelationshipacrossspecies.

5. Thenaturalresourcecurse

A distinctive feature of many natural resourceendowmentsisthattheyarenotwidelydispersedamongcountries,butratheraregeographicallyconcentratedinafewfixedlocations.Thishelpstoexplainwhynaturalresources often represent a disproportionate share ofeconomicproductionandexportsincertaincountries.46Oil-andmineral-richeconomies,forinstance,frequentlyexhibit very high ratios of natural resources tomerchandiseexportsandtoGDP.Itisoftenclaimedthatsuch resource abundance does not always lead tosustained economic growth and development for thecountries concerned, and that in fact it can have theoppositeeffect–aphenomenontermedthe“resourcecurse hypothesis” or the “paradox of plenty”. Thefollowingsectionsurveys the theoreticalandempiricalliteratureonthemechanismsthroughwhichthenaturalresource curse might operate, and tries to draw somebroadconclusionsaboutitsrelevance.

(a) The“Dutchdisease”

Anincreaseinrevenuesfromnaturalresourcescande-industrialize a nation’s economy by raising the real

exchange rate and thus rendering the manufacturingsector less competitive. This tendency towards de-industrializationhasbeencalledthe“Dutchdisease”.47

De-industrializationfollowinganaturalresourcesboomcan be of two types: direct and indirect.48 Direct de-industrialization, or “factor movement effect”, refers tothe shift in production towards the natural resourcessector. In an economy with three sectors, naturalresources,manufacturingandasectorproducingnon-tradedgoods,theboomingnaturalresourcessectorwilltakefactorinputs(includinglabour)awayfromtherestoftheeconomy.Thiscreatesanexcessdemandfornon-tradable goods, thus the relative price of non-tradedgoodsincreases.Iftheeconomyissmall,withthepriceof traded goods determined on world markets, this isequivalenttoanappreciationoftherealexchangerate,whichmakesthemanufacturingsectorlesscompetitive.

Indirect de-industrialization, or the “spending effect”,referstothefactthatadditionalspendingcausedbytheincrease in natural resource revenues results in afurtherappreciationoftherealexchangerate.Namely,the extra revenues originating from the resourceexportsboomraisedomesticincomeaswellasinternaldemandforallgoods.Sincethepriceoftradablesisseton world markets, the additional spending boosts therelative price of non-tradables – resulting in a furtherappreciationoftherealexchangerate.49

Inaneconomymarkedbyperfectcompetitioningoodsandfactormarketsandconstantreturnstoscale(theso-called “neoclassical economy”), the decline in thetradedsectorimpliedbytheDutchdiseaseshouldnotbeviewedasaproblem,letalonea“curse”,becauseitis optimal for countries to specialize in those sectorswheretheyhaveacomparativeadvantage.TheDutchdisease becomes a problem if the shrinkingmanufacturing sector is characterized by positivespilloversontherestoftheeconomy(vanWijnbergen,1984; Sachs and Warner, 1995). Krugman (1987)considers the case in which in the manufacturingsectorproductivityincreaseswithproduction(learning-by-doing). In the short run, a natural resource boomraisesthewageintheboominghomeeconomy,relativeto the foreign economy. Because the home country’sincreaseinrelativewageworsensthecompetitivenessof the manufacturing sector, the production of somegoods inthissectormovesabroad,andthebenefitoflearning-by-doing is foregone. The home country’srelativeproductivityworsensinthosegoodsovertime,so when the resource boom ends, market share andrelativewagewillhavebeenpermanentlyreduced(seeBox10foramoreanalyticaldiscussionoftheKrugmanmodel).

Table6:The effects of trade on the common access problem (small country case)

SPECIESRELATIONSHIP AUTARKY TRADE

Positiverelationshipbetweenspecies Under-harvesting Over-harvesting

Negativerelationshipbetweenspecies Over-harvesting Under-harvesting

Prey-PredatorrelationshipPredator:Over-harvestingPrey: Under-harvesting

Predator:Under-harvestingPrey:Over-harvesting


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If the manufacturing traded sector is the “engine” ofeconomicgrowth(Lewis,1954)foracountry,becauseofproductionexternalities, increasing returns toscaleorlearningbydoing,acontractioninitsoutputinducedbytheDutchdiseaseislikelytoreduceitsgrowthrate,withpermanentnegativeeffectsonincomelevels.ThispointisillustratedinFigure16.50Supposetherearetwoidenticaleconomies,bothinitiallygrowingatthesamerate, so that GDP proceeds along the straight linebetween point O and point A. Now suppose that oneeconomyhasaresourcesboomattimeT0sothatGDPimmediately rises to point B. In the short run, thiseconomy will have a higher GDP. However, if theresourcesboomcausesadeclineingrowthbecauseitdrags resources from the growth-producing sector,GDPintheboomingeconomywilleventuallyfallbelowGDP in the other economy. Even if the boomingeconomyeventuallyrevertstoitspre-boomgrowthrate,itmaystillhaveapermanentlylowerlevelofGDPthantheothereconomy.51

TheDutchdisease,anditspotentialnegativeeffectsonincomelevels,canoccuronlyiftherealexchangerateappreciates following a natural resources boom.

However,theremightbeanumberofreasonswhytherealexchangeratedepreciates,ratherthanappreciates,under such circumstances. For instance, the realexchangeratemightdepreciateifthenon-tradedsectoris more capital intensive than the traded sector, andlabourisneededtosecurethewindfallnaturalresourcerevenues(CordenandNeary,1982).52Realdepreciationcanalsooccurinthepresenceoflearning-by-doingandinter-sectoral learning spillovers. In a modelincorporatingthesetwofeatures,Torvik(2001)showsthataforeignexchangegiftresultsinarealexchangeratedepreciation in the long run,due toashift in thesteady-state relative productivity between the tradedand the non-traded sector. In contrast to standardmodelsoftheDutchdisease,productionandproductivityinbothsectorsmaygoupordown.

Allowingforrealexchangeratedepreciationrevertsthetheoretical underpinning of the Dutch disease. Sincewelackempiricalstudiesonwhethernaturalresourcebooms are associated with real exchange rateappreciation or depreciation, the link between suchboomsandde-industrializationbecomesmoretenuous.Themacroeconomicsituationisalsolikelytoaffectthe

Box10:Krugman’s model of Dutch disease with learning-by-doing

Krugman(1987)extendstheRicardianmodelwithacontinuumofgoodsofDornbuschetal.(1977),byassumingthatunitlabourrequirementsevolveovertime.Respectively,theunitlabourrequirementinsectorzattimetisequaltoa(z,t)athomeandtoa*(z,t)abroad.Asshowninthefigurebelow,thescheduleofrelativeproductivitiesA(z,t)=a(z,t)/a*(z,t) isastepfunction,becausespecializationpatternsbecomeentrenchedwith learning-by-doing.Theequilibrium in themodel isobtainedat the intersectionbetweentherelativeproductivity functionA(z,t)and thebalanceofpaymentsequilibriumcondition,BP.Anatural resourcesboom,modelledasapuretransferTfromtheforeigncountrytothehomecountry,shiftstheBPcurveinward(equilibriummovesfromAtoB).Therefore,intheshortrun,thetransfer(resourcesboom)raisestherelativewageintherecipienthomecountry(boomingeconomy)fromω0toω1.Thehomecountryhasacomparativeadvantageintradables,z,aslongasitsrelativewageislowerthanitsrelativeproductivity.Withalargetransfer,theincreaseinωisenoughtooffsetthehomecountry’sproductivityadvantage,thussomesectorsmoveabroadandzfallsfromz0toz1.

Becauseof foregone learning-by-doing, the shift inproduction from thehome to the foreigncountry impliesdecliningrelativehomeproductivityinthesectorsbetweenz0andz1overtime.Graphically,theA(z,t)functiondevelopsamiddlestep,whichdeepensovertime(downward-pointingarrowsinthefigure).Inthelongrun,ifthetransferisofsufficientlylongduration,thosesectorsremainabroadevenwhenthetransferends.Inotherwords,manufacturingexportsectors–hitbythelossofcompetitivenessinducedbyanaturalresourcesboom–areunabletorecoverwhennaturalresourcesrunout.Long-runwelfareinthehomecountryispermanentlydepressed.

B

Z1 Z0

ω1

ω0 A

BP

BP'

Home's relative wage

Number of non-tradedsectors at Home

Step productivityfunction due towell-establishedspecialization patterns


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likelihood of de-industrialization following a naturalresourcesboom. Iftheeconomyisatfullemployment,theaggregate response toaspendingboomnormallyruns into diminishing returns, reducing the value ofspending. This is because spending translates intohigher prices and crowds out alternative activities,rather than drawing more resources into use. Higherdomesticpricesshowupasa realappreciationof thecurrency,thebasisforDutchdiseaseeffects.However,if there are under-employed resources (“Keynesianeconomy”), this crowding-out effect need notmaterialize. In this case, extrademandcanbemetbydrawing under-employed resources into use. Due tomultipliereffects,thefinalincreaseinincomeislargerthan the increase in demand. Income will continue toriseuntiltheincreaseinincomeequalstheextraforeignexchange supplied by the windfall divided by themarginalpropensitytoimport(Collieretal.,2009).53

The theoreticalpredictionsof theDutchdiseasehavebeen tested both in simulations and econometricanalyses, which indicate that the phenomenon isempiricallyrelevant.Severalstudieshavemeasuredthenet effect of expansion in the energy sector on theoutputofothertradablesectors.Inasimulationmodelof a multi-sector open economy, Bruno and Sachs(1982) show that this effect is negative, with its sizedependingongovernmentbudgetpolicies concerningthe redistribution of oil-tax revenues to the privatesector.Otherstudiesuseaneconometricapproachtoexamine the impact of energy booms on themanufacturing sector. In a cross-country studycomprising Norway, the Netherlands, and the UnitedKingdom, Hutchison (1994) finds little empiricalevidencesupportingtheDutchdiseasehypothesisthataboomingenergysectorwilldrawresourcesoutofthemanufacturing sectors (Norway being the onlyexception, and the adverse effects were short-term).However, Brunstad and Dyrstad (1992) explain thatHutchison’s analysis is most likely to capture effectscomingthroughthespendingchannel.InastudyusingNorwegiandata,theyfindthatmanufacturingindustrieshave been affected by the energy boom through theresources movement effect rather than through thespendingeffect.54

Other studies have looked at the effects of resourceabundanceonthegrowthofthemanufacturingsector,using data from many countries. In a cross-section of52countries,SachsandWarner(1995)showevidencethat resource-intensive economies did indeed haveslowergrowth inmanufacturingexports, after holdingconstant the initial share of manufacturing exports intotal exports.55 Themost direct test ofDutchdiseaseeffectsisprovidedbythegravitymodelofStijns(2003),whoestimatestheimpactofanaturalresourcesboomon real manufacturing exports. The author finds theDutch disease hypothesis to be empirically relevant.Theprice-ledenergyboomtendstosystematicallyhurtenergy exporters’ real manufacturing trade. A 1 percent increase inacountry’snetenergyexportsanda1 per cent increase in the world energy price areassociated with a reduction in the energy exportingcountry’s real manufacturing trade of 0.47 per centand0.08percent,respectively.

(b) Weakeningofinstitutions

Itwouldseemthattheresourcecurseoperatesinsomepoliticalcontexts,butnotinothers.Andthatitisstronglyassociated with certain natural resource sectors, butleavesothers largely immune. Inattempting toexplainthesedifferences,theoriesstressingpoliticaleconomyconsiderations, such as rent-seeking, have gainedprominence(DeaconandMueller,2004).

Institutions,suchaslegalsystems,havebeenshowntobe crucial determinants of growth and development(Acemoglu et al. (2001) and Rodrik et al. (2004)).Resource dominance will therefore have an indirecteffect on economic growth through institutions –beyondanydirecteffectthroughde-industrialization.Itcan either hamper growth in the presence of weakinstitutions, or it can itself contribute to institutionalweakening.

First,resourceabundancehamperseconomicgrowthinthe presence of weak institutions, such as poorlydefined property rights, poorly functioning legalsystems,weakruleoflawandautocracy.Forinstance,BulteandDamania(2008)claimthatunderautocratic

Figure16:A permanent reduction in GDP following a resource boom

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leadership,policiesareguidedbythedesiretoextractbribesfromfirmsratherthanbywelfareconsiderations.56Whenaresourcesboomoccurs,thevalueofgovernmentsupport for the resources sector increases, therebyraisingthe incentivestobribethe incumbent.Sectoralsupport policies become more biased towards theresourcesindustryattheexpenseofmanufacturing.Ifthe latter sector benefits from network effects andotherspillovers,thefactthatit isreceivinglessthanasocialoptimumlevelofsupportworkstothedetrimentofeconomicgrowth.

Second, when natural resource booms occur, theremightbeatendencyforinstitutionstoweakenbecauseof rent-seeking. On the demand side, agents have anincentive to engage in rent-seeking to appropriatesomeoftheresourceincomeavailableintheeconomy(so-called “voracity effect”, described by Tornell andLane, 1999). On the supply side, a natural resourceboomcanstimulatecorruptionamongbureaucratsandpoliticians who often allocate the rents deriving fromthe exploitation and exportation of natural resources.When agents switch from profit-making economicactivities to rent-seeking activities, it generatesnegativeself-reinforcingeffects thatmore thanoffsettheextraincomefromresourcerevenues,thusloweringsocialwelfare.

In their pioneeringempirical study,SachsandWarner(1995) argue that resource-rich economies generallygrow at a slower pace. Countries with high ratios ofnaturalresourceexportstoGDPin1970werefoundtohave low average annual rates of growth in real GDPover the two subsequent decades.57 This negativecorrelationremainssignificantaftertakingintoaccountothertraditionaldeterminantsofgrowth,suchasinitialincome level, trade openness, investment rates, andinstitutional quality (see also Torvik, 2009). However,thisbroadconclusionhasbeencontestedbyanumberof follow-up studies. For instance, Papyrakis andGerlagh (2004) find that while resource wealth(measuredbytheshareofmineralproductioninGDP)seems to impedeeconomicgrowth, thecoefficientonthis measure of resource abundance becomesinsignificant – and even turns positive – after takingintoaccountcorruption,investment,openness,termsoftradeandschooling.

Sala-i-MartinandSubramanian(2003)useatwo-stageempiricalstrategytodemonstratethatnaturalresourceshave strong, robust and negative effects on long-rungrowth,butonly indirectly via theirdetrimental impacton political and social institutions.58 Once institutionsare taken into account in their growth regressions,natural resources either have little remaining harmfuleffects or even beneficial effects. However, thisconclusion isdisputedbyAlexeevandConrad(2009),who claim that the statistically significant negativecoefficients of the resources (oil) wealth in theinstitutional quality regressions presented in Sala-i-Martin and Subramanian (2003) are largely aconsequenceofthepositivelinkbetweenGDPandoil,ratherthansomesubstantivenegativeinfluenceoftheoilendowmentoninstitutions.

Finally,somestudiestestthehypothesisthatresourceabundancenegatively affectseconomicgrowth in thepresence of growth-adverse institutions, by includinginteraction effects between resource abundance andinstitutionalquality.Mehlumetal.(2006)findapositiveand significant interaction, which implies that incountrieswith institutionsofsufficientquality there isnoresourcecurse.Thisresult,too,hasbeencontestedbyAlexeevandConrad(2009).Theyclaimthatthereisno negative indirect effect of resource abundance onthequalityof institutionswhenpercapitaGDP, ratherthanaveragegrowthratesoveragivenperiodoftime,isused as a dependent variable.59 They conclude thatcountrieswithgood institutions thatwouldhavebeenrichanywaytendtobenefitlessfromthepositiveeffectof natural resources, while countries with weakinstitutionsthatwouldhavebeenpoorintheabsenceofsubstantial natural endowment reap relatively largebenefitsfromtheirnaturalresourceswealth.

(c) Conflict

Themostseveremanifestationoftheresourcecurseisthe onset, or continuation, of civil conflict. Two widelycitedexplanationsofhownaturalresourcesmaycauseconflicts are the so-called “looting” (or “greed”)mechanismandthe“grievance”mechanism(CollierandHoeffler, 2004; Ross, 2004). According to the firstexplanation, primary commodities represent profitableopportunitiesforemergingrebelgroups,whocanraisemoneyeitherbyextractingandsellingthecommoditiesdirectly,orbyextortingmoneyfromotherswhodo.Byenablingnascentrebelorganizationstofundtheirstart-upcosts,natural resources increase theprobabilityofcivilwars. In thegrievancemodel, resourceextractioncreates grievances among the local people who feelthey are being insufficiently compensated for landexpropriation, environmental degradation, inadequatejobopportunities,andthesocialdisruptionscausedbylabourmigration.Thesegrievancesinturn leadtocivilwars.

The link between resource abundance and conflict isparticularlystrongforeasilyappropriable“point-source”naturalresources-thatis,resourcesthatoccurnaturallyindenseconcentrations,suchasoilandminerals,ratherthan forestry which is more diffused throughout theeconomy. These resources induce intensified rent-seeking because revenues and rents are easilyappropriable.60 Moreover, as claimed by Deacon andMueller(2004),countrieswithabundantpointresourceswill tend to evolve governance structures based oncentralized agglomeration of power directed atcontrolling those resources, and their historieswill berepletewithstrugglestoretainthatcontrol.61

Theempiricalliteratureonconflicthasinvestigatedtherole of ethnic divisions in the build up of civil wars(MontalvoandReynal-Querol,2005).Naturalresourcesareoftenunevenlydistributedwithincountries:thinkforinstance of the oil-abundant Niger Delta region inNigeria, or minerals in the Congo’s south-easternKatanga region.Morelli andRohner (2009)developa


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theoretical model where civil conflict arises from theinterconnectionbetweenunevendistributionofnaturalresourceswithinacountryandconflictsofinterestthatassume an ethnic character. Consider that there aretwoethnicgroups,groupjthatcontrolsthegovernmentand group i that is dominated. Groups i and j have toagreeonanyoffourpotentialoutcomes,twopeacefulones(peaceoracceptedsecession)andtwoconflictualones (secessionist or centrist conflict).62 Preferencesover these possible outcomes are essentiallydeterminedbythesurplus-sharingagreement–thatis,theshareoftotalsurplusofnaturalresourcesproductionaccruingtothedisadvantagedgroupi.

Iftherewereonlyoneformofconflict(centristconflict),bargainingandtransfercouldalwaysassurepeace,asthedestructionofwarcreatessomepeacedividendtobe distributed. In the presence of multiple forms ofconflict, however, it is not always possible to find anagreementthatassurespeace,becausetheremightbea war dividend that makes bargaining fail despite theavailability of credible transfers. Bargaining failure ismost likely under two conditions. The first of these iswhentheamountofnaturalresourcesextractedintheregion more densely populated with the dominatedgroup i (denoted r1) is large. The second condition iswhenthewinningprobabilityofgroupiinsecessionistconflict,relativetothewinningprobabilityofgroupiincentristconflict(pS/pC),islarge.Intuitively,forlowr1orpS/pC, secessionist conflict becomes less attractive,andthesituationwouldbesimilartowhenthereisonlyoneformofsalientthreat(i.e.centristconflict).

Theempiricalevidenceregardingnaturalresourcesandcivilconflictismixed,andsometimescontradictory.Onthe one hand, Collier and Hoeffler (2004) find thatcountries relying heavily on exports of primarycommoditiesfacehigherriskofcivilwarthanresource-poor countries, and that this is true for primarycommoditiesofall types– includingoil,minerals, andagricultural goods. On the other hand, subsequentstudieshavechallengedtheclaimthatnaturalresourcesinvite civil conflict. Brunnschweiler and Bulte (2008)findthatcivilwarcreatesdependenceonprimarysectorexports,but the reverse isnot true,and that resourceabundance isassociatedwithareducedprobabilityofwar onset. Others have noticed that the relationbetween natural resource abundance and war onsetdependsonthetypeofnaturalresourcesinvolved.

DeSoysa(2002)andFearonandLaitin(2003)suggestthat resource abundance being associated with agreaterlikelihoodofwaronlyappliestooil.Incontrast,Humphreys(2005)pointsoutthatitisdependenceonagricultural production thatmatters.Usingnewspaperreports of violent skirmishes in 950 Colombianmunicipalities between 1988 and 2005, Dube andVargas (2006) find that violence was negativelycorrelatedwithcoffeepricesinlocationswherealargefraction of land area was under coffee cultivation. Inother words, more violence occurred when coffeeprices were low. The opposite was true for oil: it washigher prices that intensified conflict in areas withproductiveoilwellsorpipelines.63

Thestudiesfocusingonconflictdurationdonotreachconsensus either. Doyle and Sambanis (2000)demonstratethatcivilwarsarehardertoendwhentheyoccur in countries thatdependonprimary commodityexports.However,Collieretal.(2004)showthatprimarycommodities have no influence on the duration ofconflicts. The most solid pattern identified by thisliterature isthat“lootable”commoditiesthatarepronetocontraband,suchasgemstonesanddrugs,arelinkedtothedurationofconflict.Forinstance,Fearon(2004)finds that gems and drugs tend to make wars lastlonger.64

(d) Isthenaturalresourcecurseempiricallyrelevant?

As already noted, the claim that resource-richeconomies generally grow at a slower pace has beenchallenged and qualified in empirical work followingSachsandWarner(1995).Anumberofrecentstudieshavefurtherquestionedthevalidityofpreviousempiricaltestsoftheresourcecursehypothesis,basedondoubtsaboutthemeasuresofresourceabundance,thefailuretotakeintoaccountadditionalvariablesthatarelinkedwithresourceabundanceincross-countryregressionsand the failure to assess the impact of resourcedepletionoverthesampleperiod.

Thefirstcritiqueconcernshowsensitive the resourcecurse is to the measurement of resource abundance.LedermanandMaloney(2007)usenetnaturalresourceexports per worker to measure resource abundance,finding that it has a positive effect on growth. Anynegative impact on growth relates to the high exportconcentration that is typical of resource exporters.Rambaldi et al. (2006) and Brunnschweiler and Bulte(2008),ontheotherhand,argueinfavourofalternativemeasures of resource abundance to replace thecommonly used output- and export-related variableswhicharepronetoendogeneityproblemsandcanleadto biased estimates. Endogeneity is an econometricproblemthatmayemerge, forexample,becausethereisatwo-wayrelationshipbetweenacountry’seconomicgrowthanditsnaturalresourceexports.Theysuggest,respectively,using(non-renewable)resourcerentspercapita and total natural capital, or mineral resourceassets, in US dollars per capita. With such measures,thenegativerelationshipbetweenresourceabundanceandeconomicgrowthno longerholds.Rambaldietal.(2006)donotfindeitherdirectorindirectevidenceofaresourcecurse.BrunnschweilerandBulte(2008)showthat resource abundance is significantly associatedwithbotheconomicgrowthandinstitutionalqualitybut,contrary to the predictions of the resource cursehypothesis,greaterresourceabundanceleadstobetterinstitutionsandfastergrowth.65

The second critique concerns the issue of omittedvariables. Manzano and Rigobon (2007) find that thenegativeinfluenceofresourceproductiononeconomicgrowthisconfirmedinthecross-sectionalframeworkofSachsandWarner(1995),butthattheresultdisappearsin fixed effects panel regressions. This indicates the


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omission of one or more variables correlated withresource abundance, which biases the regressioncoefficients in thecross-sectionalwork.ManzanoandRigobon(2007)arguethattheomittedvariableisdebt-to-GNP ratio, which is positively correlated withresource abundance. When debt-to-GNP ratio isincludedinthecross-sectionalestimates,theresourcecurse disappears. The message, as emphasized byDavis (2008), is that a large pre-existing public debtand inappropriate risk management, rather thanresourceabundance,aretheproblem.

Finally,Davis (2006)andAlexeevandConrad (2009)notice that, even if the existing empirical literature iscorrect,itispossiblethatalargeresourceendowmentresults in high growth rates in the early stages ofextraction and slower growth rates as depletion setsin.66 Davis (2006) shows that after taking changes inthelevelofresourceproductionoverthesampleperiodintoaccount,theresourcecursedisappears:economieswith shrinking minerals-sector output saw slowergrowth,whilethosewithincreasingmineraloutputgrewfaster. This observation may also help to explain whysomestudiesfindevidenceofa resourcecurse,whileothers do not. Measuring the rate of minerals outputonly at the start of the growth period would tend toidentifymineralproducingcountriesthataresubjecttodepletion, not those that are subject to slow growth.

Likewise,measuringtherateofmineralsoutputattheend of the period would tend to identify as mineralproducing countries those whose mineral output hasgrownoverthesampleperiod.This iswhypapersthatmeasuremineralproduction(orreserves)neartheend of the sample period find no evidence to support theresourcecurse(BrunnschweilerandBulte(2008)isanexample), while Sachs and Warner (1995) and otherswho measure mineral production at the start of thesampleperiodfindtheopposite.

In order to take into account the effect of resourcedepletion, Alexeev and Conrad (2009) measure long-term growth via GDP per capita levels rather than bycalculating growth rates over a given period of time.Their conclusion is that countries endowed with oilresources tend to have relatively high levels of GDP,suggesting that natural resources enhance long-termgrowth.

Inconclusion,theempiricalliteraturedoesnotreachaconsensus on whether natural resource abundanceleadstoslowerorfastergrowth.Whatdoesseemclearisthattheliteraturehasprogressivelymovedawayfromthe initial consensus on the existence of a “resourcecurse”andtowardsamorebenignviewoftheimpactofnatural resourceabundanceoneconomicgrowth(seeexampleinBox11).

Box11:How Botswana escaped the resource curse

The mineral sector in Botswana – largely dominated by the diamond industry and, to a smaller extent, bycopperandnickelmining–hasbeenamajorgeneratorofeconomicproduction,government revenuesandexportearnings.ThemineralsharesoftotalGDP,governmentrevenuesandexportearningsincreasedfromalmostzeroin1966(yearofthefirstdiamondminediscovery)toaround50percent,60percentand90percent, respectively, in 1989 (Sarraf and Jiwanji, 2001). Mineral development has led to an extraordinaryeconomicrecord.GDPgrewatanannualaverageof13.9percentintheperiod1965-80,11.3percentintheperiod1980-89,and4.75percentintheperiod1990-98(SarrafandJiwanji,2001).

Thereasonunderlyingthecountry’ssuccessisthewayinwhichthemineralboomofthe1970swashandled.Botswanabeatthenaturalresourcescursethankstosoundmacroeconomicpoliciesandprudentmanagementof windfall gains (Modise, 1999). The government essentially decided not to increase public spendingwhenever mineral revenue increased, but to base expenditure levels during boom periods on longer-termexpectations of export earnings. This is relatively unusual behaviour in a booming economy, where thetendencyistoover-spendwhentimesaregood(seeSectionD.5).Instead,anyexcessrevenuewasusedtoaccumulateforeignexchangereserves,andbuildupgovernmentsavingsandbudgetsurpluses.Theseweredrawn on in leaner years, thus avoiding drastic expenditure cuts and/or surges in public borrowing andexternaldebtwhenexportreceiptsstartedtodecline.Suchpolicyconductwasastrongstabilizingforce;ithelped reduce inflationarypressures,keephealthypublicfinances,andset theeconomyonasustainablegrowthpath.

Botswana also escaped the “Dutch disease” thanks to the accumulation of international reserves, whichsterilized the monetary impact of the mineral export surge and prevented the national currency fromstrengthening.Thiscontroloverthenominalexchangerateallowedothertradablegoods(namelymanufacturers)tomaintaincompetitivenessonworldmarkets, andhenceencouragedeconomicdiversification.Preservingjobs(orpromotingthecreationofnewones)innon-mineralsectors,includingservices,provedhighlybeneficial,giventhatthelabourrequirementsofthemineralsectorarelimitedbythecapital-intensivenatureofminingoperations(SarrafandJiwanji,2001).Therefore,thankstoacombinationofmineralwealthandhigh-qualitypoliticalinstitutionsandmacroeconomicmanagement,Botswanaachievedoutputandemploymentgrowth.


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6. Naturalresourcesandpricevolatility

SectionB.1(e)notedthatanimportantcharacteristicofnatural resources is their price volatility over certainperiods of time. In the past, these price swings wereprincipally supply-driven, often linked to geopoliticalevents–anexamplebeing theoilpriceshocksof theearly and late 1970s. More recently, demand-drivenfactors,suchastherapidincomegrowthofkeyemergingmarkets, have also influenced resource prices (Kilian,2009b). This is particularly true for the most recentcommodity boom – one of the largest and most long-lastinginhistory,coveringabroadrangeofcommodities–wherenosingleandstraightforwardcauseexistsfor

thepriceaccelerationandsubsequentdecline.Thisisanimportantdevelopment,sincetheeconomicimplicationsof volatility may differ depending on the underlyingfactorsdrivingthesuddenswingsincommodityprices.Box12discussestheaboveargumentforthecaseofoil.

From2003toearly2008,thepricesofawiderangeofcommoditiesrosesharplyandoverasustainedperiodoftime.Bymid-2008,energypriceswere320percenthigherindollartermsthaninJanuary2003,andminingproductswere296percenthigher.ByNovember2008,however, all commodity prices were falling, with thedollarpriceofcrudeoilhavingfallenmorethan60percent(WorldBank,2009).Thisconsiderablevolatilityincommodity prices can be seen in Figure 17 whichdepicts price trends for major commodity groups.

Figure17: Real prices of selected commodities, Jan. 2000-Aug. 09 (IndexAverageofYear2000=100)

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Box12:economic implications of the changing nature of oil price shocks

ThelargeincreasesinthepriceofoiltriggeredbytheArab-Israeliwarin1973,andtheIranianrevolutionof1979,respectively,havebeenconventionallyassociatedwithlowgrowth,highunemploymentandhighinflationinmost industrializedeconomies.Since the late1990s,however, theglobaleconomyhasexperienced twoperiodsofoilpricevolatilityofamagnitudecomparablewiththoseofthe1970sbut,incontrastwiththelatterepisodes,GDPgrowthandinflationhaveremainedrelativelystableinmuchoftheindustrializedworld.

Ithasbeenargued that improvements inmonetarypolicy, the lackofconcurrentadverseshocks,asmallershareofoilinproductionandmoreflexiblelabourmarketsallplayedanimportantroleindeterminingthemildeffectsoninflationandeconomicactivityoftherecentincreaseinthepriceofoil(BlanchardandGali,2007).However,theliteraturehasnotfoundaconsensusonthispoint.

EdelsteinandKilian(2009)andKilianandLewis(2009)arguethatthereisnocompellingevidencethattheevolutionoftheshareofenergyinconsumerexpendituresorinvalueadded,adeclineinthevolatilityormagnitudeofenergypriceshocks,reducedreal-wagerigidities,orimprovedmonetarypolicyresponsescanexplainthedecliningimportanceofoilpricevolatility.Apossibleexplanationofthisphenomenonthathasbeenadvancedrelatestochangesinthenatureoftheoilpricefluctuations.Forinstance,therecentsurgeinthepriceofoildidnotcauseamajorrecessionevenafteryearsofrisingoilpricespartlybecause,unlikeinthepast,muchofthat increasewasdrivenbyunexpectedstrongglobaldemandforindustrialcommodities(Hamilton,2009a).67Suchglobaldemandshockshavebothastimulatingandanadverseeffectoneconomicgrowth,withthelatterworkingthroughhigheroilandcommodityprices.EmpiricalestimatesfortheUSeconomysuggestthat,intheshortrun,thepositiveeffectsarestrongenoughtosustaingrowth,asglobalcommoditypricesareslowtorespondandtheworldeconomyisbooming.USrealGDPgraduallydeclinessubsequently,asenergyprice increasesgainmomentumandtheeconomicstimulusfromhigherglobaldemandweakens(Kilian,2009c).Amorecompletediscussiononthecausesofrecentcommoditypricevolatilityisprovidedbelow.


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Figure 18 depicts a similar boom and bust cyclefor different energy commodities, the categorycharacterizedby thehighestprice volatility. Figure19does the same for a metal commodity and contraststhiswiththemarketsforplywood(forestryproduct)andfish. The dramatic acceleration of prices from 2006onwards for a range of commodities created thesuspicion that, in addition to fundamental economicfactors,priceswerebeingpushedupbya“speculativebubble”(TalleyandMeyer,2008).

Thissub-sectionreviewspossibleexplanationsfor theobserved commodity price volatility in recent times,starting with the controversial debate on the role of“speculators” (i.e. non-traditional investors betting onpricemovementswithnointerestinphysicallyacquiringtheunderlyingcommodity)indrivingprices.Thereafter,theroleoffundamentaleconomicfactorsinexplainingthe recent period of commodity price volatility will be

discussed. The sub-section concludes with a briefreview of some of the consequences of commoditypricevolatilityinbothimportingandexportingcountries.

(a) Speculationincommoditymarkets

(i) Speculation: definition

“Speculation”isoftenreferredtoastheassumptionoftheriskoflossinreturnfortheuncertainpossibilityofareward (Robles et al., 2009). It usually entails thepurchaseofanassetforresaleratherthanforuse,orthe temporary sale of a borrowed asset with theintention of repurchase at a later date in the hope ofmakingaprofitfromapricechangeinthe interveningperiod. Inotherwords,speculatorscanbeonthelongorshortsideofatransaction,wheretheformerreferstothepurchaseofanassetwiththeexpectationthatitwillriseinvalueandthelatterimpliesthesaleofaborrowed

Figure19:Real prices of nickel, plywood and fish, Jan. 2000-July 09 (Index,AverageofYear2000=100)

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Figure18: Real prices of energy commodities: oil, natural gas and coal, Jan. 2000-Aug. 09 (Index,AverageofYear2000=100)

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Note: PricesaredeflatedbyworldCPI,averageofyear2000=100.Source: IMF,InternationalFinancialStatistics.


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asset with the expectation that it will fall in value.Speculation may be driven by expectations of futuredemand and supply, which represent marketfundamentals, or by self-fulfilling expectations thatresultinaspeculativebubble.

(ii) Speculation: theory

Inaseminalarticle,Fama(1970)presentedthecaseforthe“EfficientMarketHypothesis”(EMH),whicharguesthat prices are always consistent with marketfundamentals. The underlying logic is that, assumingrational expectations and perfect information (e.g. inthe stock market), prices fully reflect all knowninformation, thereby implying that tomorrow’s pricechange will reflect only tomorrow’s news and will beindependentofthepricechangestoday.However,newsis,bydefinition,unpredictableand,thus,resultingpricechangesmustalsobeunpredictable.68 In thiscontext,prices may change in response to any news aboutfuture demand or supply because it alters theexpectationsofmarketparticipants.Such“speculative”shockshavetheirroots,however,inmarketfundamentalsand are consistent with the EMH. This is becauseforward-looking expectations of traders areincorporated into their actions today and hence arereflectedincurrentprices.

Over time, the intellectual dominance of the EMH hasdiminished,largelyduetotheemergenceof“behaviouraleconomics”, which argues that psychological elementsmake prices at least partly predictable (DeLong et al.,1990;ShleiferandVishny,1997;AbreuandBrunnermeier,2003; Miller, 1997; Harrison and Kreps, 1978;Scheinkman and Xiong, 2003). It emphasizes a“feedback”, “bandwagon” or “herding” effect that isindicativeofthe“irrationalexuberance”(Shiller,2000)ofmarket participants, which leads to self-fulfillingspeculative bubbles.69 This divergence of prices fromtheir fundamental values may be explained as follows.When prices go up, it generates word-of-mouthenthusiasmandheightensexpectationsforfurtherpriceincreases. In turn, this increases investor demand, andthusgeneratesanother roundofprice increases. If thisfeedbackisnotinterruptedoveraperiodoftime,itcreates

a speculative bubble, in which high expectations forfurtherpriceincreasessupporthighcurrentprices.

Thehighprices,however,areultimatelynotsustainable,since they are high only because of expectations offurtherpriceincreases.Hence,theboomisfollowedbyabust(Stiglitz,1990;Brunnermeier,2008).Anecdotalevidence of such self-fulfilling speculative bubblesincludestheriseandcrashofthestockmarketduringthe1980s, thedot-combubble in the late1990sandexchange rate overshooting in the Republic of KoreaandThailandin1997(FloodandHodrick,1990).

(iii) Speculation in commodity markets: the role of non-traditional investors

Thespeculationdebateincommoditymarketscentreson the role of non-traditional investors, such as indexfunds,70hedgefundsandotherswhohavenointerestinbuying or selling the actual underlying commodity(Masters,2008;Roblesetal.,2009).Sincetheydonottakeormakephysicaldeliveryofthecommodity,thesenon-traditionalinvestorsparticipateinfuturesmarkets,but not in spot markets, where physical delivery of aproduct is immediately arranged. They engage infutures trade to make a profit from the successfulanticipation of price movements (United NationsConference on Trade and Development (UNCTAD),2001). For example, a speculator might purchase afuturescontracttodaybelievingthatonce itexpires insix months, it will sell for a higher price. A speculatorthereby enables hedging by taking on risk that othermarketparticipantswanttoshed(seeBox13).

The increasing importance of these non-traditionalinvestorsincommoditymarketsduringthelastfewyearsis attributable to the following. First, natural resourcecommodities have emerged as a new “asset class”,enablinginvestorstobetterdiversifytheiroverallportfolio.This is because commodities are negatively correlatedwithotherassetclasses,suchasstocksandbonds,butpositively correlated with inflation (Gorton andRouwenhorst,2004).71Second,lownominalinterestratescoupled with inflation can lead to the availability of“cheaper-than-free money”,72 thus enabling investors to

Box 13: Investment in commodity futures: providing insurance

Takingtheexampleofthelivecattlemarket,Greer(2005)describesthecrucialrolethatfuturesinvestorscanplayinprovidingpriceprotection.Assumingthataproducerhascattlecomingtothemarketsixmonthsfromnow,he/shewillmarketthecattleregardlessofprice.Obviously,theproducerwillneedtocoveritsunitcostsofproductionifitwishestostayinbusiness.Ifthereisacommonbelief(assumingmarketsareefficient)thatpricewillbe10percenthigherthancostatthatfuturepointintime,itwouldbeadvantageousfortheproducertolockinthispricewiththeclientatthepresentday.However,theprocessor(buyer)maynotbeamenabletosuchadeal.Ifthebuyersellsacertainamountofprocessedmeattoasteakhouseatmarketprice,thesamepriceprotectionasthecattleproducerisnotneeded.

In fact, if theprocessorwere to lock in the input costwithouthavingaguaranteedsalespriceof thefinalproduct,theprocessorwouldbeincreasingitsbusinessrisk.Bycontrast,afuturesinvestormaybewillingtotakeontheproducerpricerisk,albeitatadiscount(“insurancepremium”).Bythesametoken,theproducerisnowsuretosellitscattlewithabenefit,althoughataslightlylowerpricethancurrentlyexpected.Bothparties“win”(unlikeinfinancialfuturesmarkets,whichareoftenconsideredtobe“zero-sum”),sincetheobjectivesofproducersinthecommodityfuturesmarketaredifferentfrominvestorobjectives.


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Besides the riskpremium, another componentof total return is rather specific to investment in commodityfuturesandhas todowithcommodityconsumption relative to inventories.Stayingwith theexampleabove,assumethatasthedeliverydateapproaches,cattlesupplyturnsouttobelowerthanexpected(e.g.owingtodisease).Theprocessormaywishtoensurethatitscontractualcommitmenttosupplyacertainamountofmeattothesteakhouseishonouredandthatallprocessingcapacitiesarefullyemployed.Itmaythereforedecidetobuytheimminentfuturescontract,whichallowsittotakedeliveryatseveraldesignatedlocationsandtogaincertainty tohavesufficientanimals toprocess.At thesame time, if theanticipatedcattle shortage furtherdrivesupprices,theprocessorcanusetheproceedsfromitslongfuturespositiontohelpfinancethepurchaseofthemoreexpensivecattle.

Hence,thepriceofthenearbyfuturecontractmaygoupifprocessorsarereadytopayforthe“convenience”ofknowingthattheywillhaveenoughcattletoprocess.Dependingonthe“precariousness”andvolatilityofthemarket,this“convenience”yieldcanbeaquiteimportantsourceofreturnstoinvestors(Lewis,2005).Thishasbeenthecase,forinstance,intheoilmarket,whereshuttingdownandrestartingrefinerycapacityiscostlyanddemand is inelastic (i.e. demand is not linked to price fluctuations). In other markets, such as gold, whereinventoriesarelargecomparedwithconsumption,theconvenienceyieldhasbeenlow.However,morerecently,especiallyduetodemandfromemergingeconomies,certainindustrialnon-ferrousmetalshaveseenpositiveconvenienceyieldsduetostrongdeclinesininventories.

increasetheirdemandforcommoditiesthroughasimpleincomeeffect(Larson,2008).Third,thedevelopmentofcommodity-basedinstruments,suchasindexcertificates,hasmadeinvestmentincommoditiesmoreaccessibletoalargernumberofpeople(Greer,2005).

Insum,theincreasingimportanceofcommodity-relatedfinancialmarketscreatesnewopportunitiesaswellaschallenges. On the one hand, financial markets canenhance the liquidity of commodity trades, help pricediscovery(i.e.todeterminemarketprices)andcontributetotheefficientallocationofrisk.Ontheotherhand,thesimultaneousincreaseinpricesandspeculatorinterestin commodity futures markets can potentially magnifythe impact of supply-demand imbalances on prices.Somehavearguedthatthehighactivityofnon-traditionalinvestors has increased price volatility and pushedprices above levels justified by market fundamentals.These arguments, counterarguments and the relatedempiricalevidencearereviewedbelow.

(iv) Role of speculation in the recent commodity price boom and bust

Themainthrustoftheargumentthatcommoditymarketshave been characterized by speculation is that largeamountsofmoneyfromnon-traditionalfinancialinvestors,who take long positions in the futures market (in bothorganized exchanges and over-the-counter (OTC)markets), have resulted inasignificantupwardpressureon prices.73 This may be indicative of the “feedback” or“herding”effectmentionedabove,wherebyfuturespricesmayhavebeenhighonlybecausetheseinvestorsbelievedthat prices would be higher at a later date, when“fundamental” factors did not seem to justify suchexpectations,i.e.speculativebubbles.However,itmayalsoreflecttheexpectationsofparticipantsthatarebasedoneconomic fundamentals. For instance, suppose marketsexpect theoccurrenceofanaturaldisasteroracertaingeopoliticaleventwhichwouldadverselyaffectproductioncapacity, creating concernsabout future shortagesof aresource. This could lead to a genuine desire to holdincreasedinventories,therebypushingupprices(Costello,

2008). In this context, Kilian (2009c) argues that Iraq’sinvasionofKuwaitin1990isacaseinpoint.

Kilianarguesthatcrudeoilpricessawasignificantrisein the mid-1990s not merely because of decline inproduction in Iraq and Kuwait, but also because ofconcerns that Iraq might also invade Saudi Arabia,causingamuchlargeroilsupplydisruption.Empirically,itisdifficulttodistinguishbetweenthetwosourcesofspeculation. But given that non-traditional investorsviewcommoditiesasafinancialinvestmentandarenotnecessarily well-acquainted with the workings of thecommoditybusiness, theirbehaviour in thesemarketsmaybeassociatedwitha“herding”effect.

Asevidence,proponentsofthespeculationhypothesishighlight the increased involvement of non-traditionalinvestors in commodity markets. For example,Büyüksahin et al. (2008) report that from 2004 to2008, the market share of financial traders in the oilfuturesmarketincreasedfrom33to50percent,whiletheshareof traditional traders, suchasoil producers,refinersandwholesalers,fellfrom31to15percent.74Inaddition,asshowninFigure20forasampleofadvancedcountries,thenumberofcommoditycontractstradedinOTCmarketsincreasedinthefirsthalfof2008.Inviewofthefactthatthesearelargelyunregulatedmarkets,the argument has been made that this rise in activitymaybeindicativeoftheroleofspeculationintherecentcommoditypricehike(Masters,2008).

The empirical literature examining more specifically therelationship between speculative money flows andcommoditypricesisratherthin.WhileRoblesetal.(2009)showthatsomeindicatorsofspeculativeactivitycanhelpforecast spot price movements, other studies merelypresent anecdotal evidence or simple correlationsbetween futures investment and commodity prices(Masters,2008).Somestudiesseemtoworkundertheassumptionthatspeculatorshaveanundesirableimpactonmarketprices.Forinstance,forarangeofcommoditymarkets, Chevillon and Rifflart (2009), Cifarelli andPaladino (2009) and Sornette et al. (2009) claim thatbecause changes in supply and demand fundamentals


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cannotfullyexplaintherecentdrasticincreaseinprices,largeflowsofmoney,typicallyinlongpositions,musthavepushedcommoditiestoextremelyhighlevels.Thisleadstoanothersectionoftheliteraturewhicharguesthatthebodyof evidencedescribedabove ignores the inherentcomplexityofpricedeterminationincommoditymarketsandisoftennotbasedonrigorousstatisticalmethods.

(v) Not speculation after all?

A range of authors disagree with the proposition that“speculators” played a major role in the recentcommodity boom and bust. First and foremost, it isargued that money flows into futures markets shouldnotbeequatedwithdemandforphysicalcommoditiesbecause futures contracts are settled for cash(Hieronymus, 1977). These are zero-sum markets

where buying by non-traditional investors is “newdemand”justasthecorrespondingsellingbyhedgersis“new supply”. Second, the rigid classification oftraditionalinvestorsasrisk-avoidersandnon-traditionalinvestors as risk-seekers or speculators may notnecessarily be true. This is because many traditionaltraders speculate (Stultz, 1996) and many non-traditionalinvestorssellshortinanticipationofafuturedeclineinequilibriumprices(Frankel,2008).

Third, the participation of financial traders is limited tofutures markets, which consist of purely financialtransactions.Eveniftheirpurchaseofafuturescontractleadstoafuturepriceincrease,itseventualsalenegatestheir existing long position and their account is closed.These financial traders do not take or make physicaldeliveriesandhencedonotparticipateinthespotmarket

Figure20:notional amounts outstanding of otc commodity derivatives, June 1998-June 2009 (Billiondollars)

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Figure21:natural gas – long-short positions by class of investor, June 2006-July 09 (Ratioanddollars)

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Figure22:copper – long-short positions by class of investor, June 2006-Aug. 09 (Ratioanddollars)

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Note:Lefty-axis–Longandshortpositionsincontractunitsof25000Pounds,NYMEX,UnitedStatesofAmerica.Righty-axis–NominalspotpriceinU.S.$permetricton,LondonMetalExchange,U.K.(originalmonthlydatalinearlyinterpolatedtogetweeklydata).Source: UnitedStatesCommodityFuturesTradingCommissionandIMF,InternationalFinancialStatistics.

Figure23:united states monthly oil stocks and oil price, Jan. 1986-Aug. 2009 (Tenmillionbarrelsanddollarsperbarrel)

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where long-term equilibrium prices are determined(Smith, 2009; Garbade and Silber, 1983). Speculativetradingmayraisespotpricesonlyifitinducesparticipantsinthephysicalmarkettoholdcommoditiesoffthemarketandbuildupinventories(“hoarding”).

Anecdotalevidencesuggeststhatthecurrentsituationincommoditymarketsisinconsistentwiththeargumentsofa speculative bubble. First, the increase in “long”speculationhasnotbeenexcessivewhencomparedwiththe increase in “short” hedging (Irwin et al., 2009).Second,speculatorshaveoftenbeennet “short”sellersratherthan“long”buyers.Hence,theymayhavedelayedormoderatedthepriceincreases,ratherthaninitiatingoraddingtothem(WorldBank,2009).BoththesefactsarereflectedinFigure21,whichcorrelatestheratiooflong-to-shortpositions,bycategoryofparticipant,topricesfornatural gas at the New York Mercantile Exchange(NYMEX). Itshowsthat, intheearlyhalfof2008,while

prices increased, this ratio was fairly flat for moneymanagers (investment funds). This lack of correlation,however,isnotasevidentincertaincommoditymarkets.Figure22showsthecaseforcopper.

Third,IrwinandGood(2009a)showthatfrom2006to2008,highpriceshavebeenobservedforcommoditieswithnofuturesmarkets.Furthermore,spectacularpriceincreases were concentrated in commodity marketswith little index fundparticipation,whereasmodestorno price increases were seen in markets with thehighestconcentrationof indexfundpositions(Irwinetal.,2009).Fourth,datasuggestthatinventoriesof,forinstance,crudeoilhavestayedrelativelyflatandhavefallen sharply for a range of other commodities from2005 to2008 (Smith,2009;Krugman,2008).Figure23,whichdepictsthecaseofUnitedStatesoilstocks,shows that there is no clear evidence of “hoarding”,especiallywhenpricesincreasedsteeplyin2008.


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Figure24:World oil consumption and consumption-to-proved-reserves ratio, 1980-2008 (Millionbarrelsandratio)

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Anumberofrecentstudiesuseavarietyofsophisticatedeconometricmethodstomakeamoreformalassessmentoftheroleofspeculationintherecentcommoditypriceboom (Sanders et al., 2004; Sanders et al., 2008;Sandersetal.,2009;SandersandIrwin,2009;Bryantetal.,2006).Forinstance,usingpubliclyavailabledataonpositionsofdifferenttradergroupsintheUnitedStates,Sanders et al. (2008) find that measures of positionchange have a statistically significant effect oncommodityfuturespricesinonlyfiveoutof30cases.Incontrast,reversingthecausalitytestindicatesstatisticalsignificanceinallbutthreecases.

In sum, empirical evidence points towards a range offundamental market factors as the major explanationforthedramaticincreaseincommoditypricesinrecentyears,withlessemphasisonspeculativeforces.Thisisanalysedinthesectiontofollow.

(b) Roleofeconomicfundamentalsinexplainingcommoditypricevolatility

Commoditypricesduringtherecentboommayhavebeenaffectedbyavarietyoffundamentalmarketforcesonthedemand and supply side (Irwin and Good, 2009b;Hamilton,2008;HeadeyandFan,2008).Theseincludebuoyant global economic growth, limits to increasingproduction capacity in the short-run, relative prices ofsubstitutesandgovernmentpolicies.Again,muchoftheliteratureisontheoilmarket,whichwillbeusedonseveraloccasions for illustrative purposes, but is applicable toothernaturalresourcesaswell(Davis,2009).

(i) Demand

Annual increases in the global consumption of majorcommodities from2002to2007were larger than theyhadbeenduring the1980sand1990s (Helblingetal.,2008). Strong income growth in some major emergingeconomies has been a major contributing factor in thisregard (Cheung and Morin, 2007). For example, during

thisperiod,demandfromChina,IndiaandtheMiddleEastaccounted for more than half of the growth in oilconsumptionandChinaaloneaccountedforabout90percentoftheincreaseintheworldconsumptionofcopper(Helblingetal.,2008).The lattermaybeattributabletorapidindustrializationandurbanizationcharacterizedbyahigh metal-intensity of growth in the early stages ofdevelopment(WorldBank,2009).Ontheotherhand,thesharpdecline incommoditypricessincemid-2008maybeexplained, inpart,byacontractionofworlddemandowingtoslowerGDPgrowthduringtherecession.Figure24 reveals an increasing world demand for oil, whichKilian(2009c)arguesisaresultofunexpectedgrowthinemergingAsianeconomiestogetherwithsolidgrowthintheOECD.

Figure 24 shows that while world consumption of oilincreasedfrom1980to2008,worldprovedreservesofthe commodity also increased. A falling consumption-to-proved reserves ratio until the late 1980s impliesthat reserves increased faster than consumption untilthat point in time. Thereafter, the ratio remains aboutconstantastheincreaseinprovedreservesismoreorless in tandem with rising consumption. The lesspronounced increase in proved reserves may beattributabletothetechnologicalchallengesinvolvedinexploiting non-conventional sites such as deep seafieldsoroilsands.

(ii) Limits to increasing supply capacity in the short-run

Despite the steady increase in proved reserves ofenergy commodities such as oil and natural gas,extraction, production and refinery capacity have notfollowedsuit, leadingtoasubduedsupplyresponseintheshort-run,aswitnessedduringtherecentcommodityboom.Oneofthereasonsforthelackofinvestmentinnewcapacitywasthebuild-upofidlecapacityinseveralresourcesectorsduringthe1980sand1990s,whichinturnwasattributabletothefollowing.First,foroil,global


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demand fell sharply following the 1980s oil shock.Second, for oil, metals and minerals, demand amongformerSovietbloccountriesfellbyalmost50percentduringthe1990s,asthesecountriesbegantoallocateresourcesinamoremarket-orientedway(WorldBank,2009;BorenszteinandReinhart,1994).

Giventheabove,excessdemandwasaccommodatedbyarun-downofinventories,andpricesincreasedwhenallidlecapacitywasfinallyabsorbedinthefirsthalfoftheearly 2000s (Helbling et al., 2008). Figure 25 showsthat in the case of oil, for example, refinery capacitydeclined or remained relatively constant from 1980 tothe early 1990s, after which it saw an upward trend.Despite this, we can see that the consumption-to-refineryratioremainedrelativelyconstantfromtheearly1990s to 2006, implying that consumption grew atapproximatelythesamerate.Thisreinforcesasectionofthe literaturewhichargues thathighandsustainedoilprices after 2003 are primarily driven by demand,especiallybecausetheabilitytoincreaseproductionorrefininginthenearfutureislimited(Kilian,2009c).

Higheroilpricesdonotstimulateglobalproduction inthenearfuturebecausetheshort-runpriceelasticityofoil supply is near zero (i.e. oil supply is not veryresponsive to price changes in the short-run) (Kilian,2009b).Atthesametime,inthecaseofoil,thereisnoevidence to suggest that, on the supply side, theOrganization of the Petroleum-Exporting Countries(OPEC) attempted to act as a cartel and hold backproduction from 2004 to 2008 (Smith, 2009; Kilian,2009c).Ontheflipside,highcommoditypricesduringthe boom are likely to have stimulated investment inproduction capacity, thereby alleviating supply-sideconstraints to an extent. Together with contractingworlddemand,thismayhavebeenacontributingfactorforthebustfollowingtheboom.

(iii) Linkages across commodities

Linkages across different commodity markets haveplayed a role in recent price increases. For instance,

higheroilpriceshavehadanimportanteffectonothercommoditiesnotonlythroughthetraditionalcost-pushmechanism, but also through substitution effects, e.g.naturalrubberpriceshaverisenbecauseitssubstituteis petroleum-based synthetic rubber and coal priceshave risen because of utilities switching from moreexpensiveoiltocoalforpowergeneration(Helblingetal.,2008).

Furthermore,highoilpriceshave ledtoasurge intheuseofbio-fuelsasasupplementtotransportationfuels,thereby diverting a significant share of feedstock,especiallycorn,rapeseedandsugarfromfoodsuppliesin major producing countries (Helbling et al., 2008).Thishasnaturallypushedupthepricesofsomemajorfoodcrops.Hence,thisinter-linkagemayexplainpartofthe correlation between energy price and food pricedevelopments,aspresentedinFigure17.Ontheotherhand, the bust which followed the recent boom in oilmarketsmayhavecontributedtotheoveralldeclineincommoditypricesbyreducingthedemandforbio-fuels.In the long-run, the linkagebetweenenergyand foodmarkets may weaken with the development ofalternative sources of energy, e.g. solar power (WorldBank,2009).

(iv) Effective dollar depreciation

SeveralresourcecommoditiesarepricedinUSdollarsandhencemovementsinthedollarexchangeratemayaffect demand and supply. The effective dollardepreciation seen over the past few years has madecommoditieslessexpensiveforconsumersoutsidethedollar area, thereby increasing the demand for thosecommodities(Helblingetal.,2008).Onthesupplyside,the declining profits in local currency for producersoutsidethedollarareahaveputpricepressuresonthesamecommodities(Helblingetal.,2008).

Consider a foreign firm that produces a commoditywhichispricedindollars.Adepreciatingdollarimpliesthat producers will increase prices as they demandmoredollarsfromeachsaleascompensation.Investors

Figure25:World oil refinery capacities, consumption and consumption-to-refinery capacities ratio, 1980-2008 (Capacityandconsumptioninthousandbarrelsperday)

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anticipate this and start putting money into thesecommodities, thereby driving prices higher. Hence, itmay be argued that investors have been pouringresources into the commodities market to protectthemselves against the depreciating dollar. On theflipside,withtheonsetofthefinancialcrisis,thissourceof the commodities boom reversed and possiblycontributed to the sharp price decline in mid-2008. Itwasattributabletoincreasedinvestmentin“less-risky”UStreasurybills,therebyresultinginanappreciationoftheUSdollarvis-à-visthecurrenciesofmostdevelopingcountries.

In a speech in March 2009 on the reform of theinternational monetary system, the Governor of thePeople’s Bank of China proposed a more prominentroleof the IMF’sSpecialDrawingRights(SDR)asaninternational reserve currency (Zhou, 2009). One oftheobjectivesofthisproposalistoaddressthevolatilityof commodity prices denominated in a nationalcurrency (generally US dollars). Specifically, Zhou(2009) argued that promoting the roleof theSDR ininternational trade and commodity pricing couldeffectivelyreducepricefluctuationrelativetoasystemwhere commodities are denominated in a singlenationalcurrency.75

(c) Consequencesofpricevolatilityinimportingandexportingcountries

In view of the dominance of natural resources in theeconomy of many exporters and their strategicimportance in the production of importing countries,commoditypricevolatilityhasoftenbeenofwidespreadpoliticalconcern.Below,theeffectsofvolatilityinbothexportingandimportingcountriesarediscussedinturn.

(i) Effects of volatility on natural resource exporters

Hausmann and Rigobon (2003) show that in aneconomy where an extractive resource (say, oil)represents about 20 per cent of GDP, a shock to theprice of oil has a significant effect on GDP.76 Thisempirical finding is indicative of the fact that pricevolatility has long been considered a problem forexporters thatmainly relyonnatural resourceexportsasasourceofrevenues.Theliteratureattributesthistothe following reasons: risk-averse consumers, fiscalimplications, and volatility as a channel of the naturalresourcescurse.

Risk-averse consumers

If consumers are risk-averse, volatility may have anadverse effect in exporting countries, becauseconsumersarewillingtospendsomeoftheirincomeonhedging against the risk of large swings in resourceprices. Hausmann and Rigobon (2003) hold that thisnegative impact on economic growth is likely to besmall in the absence of further disruptions to theeconomy.77

Fiscal implications

Focusing on oil exporters, Kilian (2009c) notes thatfalling prices can put serious strains on their fiscalbalancesandabilitytoborrowfromabroad.Incontrast,risingpricescantypicallybeaccommodatedeasily,byfinancing imports from the rest of the world andrecycling some of the additional oil revenues into theglobalfinancialsystem.78However,asuddenincreaseinnatural resourceswealthmay inducepolicy-makers toincreasepublicspendinginawaythatisimpossibletofinanceoncethenaturalresourcerevenuesdryup.

For instance,during theepisodesofhighoil prices inthe1970s,banksidentifiedoilproducersascreditworthyborrowers, extending them large loans. These loans,however,financedhigher importsandhigherdomesticconsumption levels,andproved tobeamiscalculationbecauseoilpricesdidnotremainhighforever.Thisledthese oil-rich countries into default, threatening thestability of the international financial system (Kilian,2009c).Similarly,after thediscoveryofnaturalgas intheNetherlandsandtheglobaloilpriceshocksduringthe1970sand1980s,successiveDutchgovernmentsrespondedwithlargepublicspendingincreases.ItthentooktwodecadestoputtheDutchwelfarestateonafinancially sustainable footing again (Van der Ploeg,2006).

Volatility and the natural resources curse

In a framework proposed by Hausmann and Rigobon(2003), volatility arises from an interaction betweenspecialization and financial market imperfections, andcanbeasourceoftheresourcescurse.79Theyconsideraneconomy that is specialized in the resources (non-tradable)sector,whichfullyemploysafixedquantityoflabour. The sector’s supply can be expanded only byincreasing the level of capital per worker. Given fixedlabour, this implies that the productivity of eachadditional unit of capital would be falling. Capital is,however,requiredtogettheinternationalrateofreturn,hence the price of non-tradables must increase. Thiswouldleadtoanappreciationoftherealexchangerate.At the same time, an increase in the price of non-tradables will cause expenditure-switching away fromthe now more expensive non-tradables into tradables,raising the price of tradables. This would lead to adepreciationoftherealexchangerate.

Unlikeadiversifiedeconomywhichwillhaveaconstantreal exchange rate because it can absorb demandshocks with intersectoral reallocation of labour, aspecialized economy will experience a volatile realexchangerate.Inaddition,ifthisspecializedeconomyismarkedbyfinancialmarketimperfections,interestratesare likely to be sensitive to the volatility in the realexchange rate. According to Hausmann and Rigobon(2003),underreasonableassumptionstheinterestrateisboundtogoupasthevolatilityoftherealexchangerate increases, making it even more difficult for theeconomy to attract investment into the “dynamic”tradable sector. The authors note that this volatility-


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induced channel of the resources curse is morecompatible with GDP and price developmentsexperienced in certain resource-rich economies thancompetingexplanations,suchastheDutchdiseaseorrent-seekingapproachesdiscussedearlier.

There is a vast literature on the negative effects ofvolatility (in commodity prices, terms of trade,unanticipatedoutputgrowthorgovernment spending)on growth performance.80 A recent study (Van derPloegandPoelhekke,2009)testsforthedirecteffectsof natural resource abundance on economic growthanditsindirecteffectsthroughvolatilityofunanticipatedoutput growth.81 The authors find that the resourcecurseexistsonlyforcountriesaffectedbyhighvolatility.Althoughthe levelof resourceabundancemayhaveapositive direct effect on growth, this effect can beswampedbytheindirectnegativeeffectresultingfromvolatility. Therefore, natural resourcesabundancemaybeacurseforcountriesaffectedbyhighvolatility(e.g.ZambiaandsomeotherAfricancountries),butaboonforthoselessaffected(e.g.NorwayandtheAsianTigereconomies). In light of these results, a reduction ofvolatility may be desirable from the point of view ofresourceexporters.

(ii) Effects of volatility on natural resource importers

Price volatility is as important a concern for naturalresource importers as it is for exporters. This can, inprinciple, be the case for any commodity imported inlargequantities,andhasespeciallybeen thecase foroil,duetoitseminentroleasaninputinproductioninvirtuallyeverysector.Sincethe1970s,andatleastuntilrecently,macroeconomistshaveviewedchangesinthereal price of oil as an important source of economicfluctuations (so-called “business cycle”), as well asa paradigm of a global shock, likely to negativelyaffectmanyimportingeconomiessimultaneously.82Thefollowing is an analysis of the various transmissionmechanisms of real oil price shocks on oil-importingeconomies, and how their relative magnitude hasevolvedovertime.

Supply-side channel

Anincreaseintherealpriceofoilfromthepointofviewofanoil-importingeconomy isa terms-of-tradeshock(i.e. an increase in the price of imports relative toexports).Suchterms-of-tradeshockstraditionallyhavebeen thought tomatter for theoil-importingeconomythrough their effectsonproductiondecisions,withoilbeing treated as an intermediate input in domesticproduction. A widely addressed but still unresolvedissueiswhether,andtowhatextent,oilpricechangescan explain real GDP fluctuations, based on thisintermediateinputcostorsupplychannel.Somearguethatoilpricefluctuationsarenotamajordeterminantofthe business cycle (e.g. Backus and Crucini, 2000)while others argue that oil price shocks exert majoreffects on real GDP (e.g. Rotemberg and Woodford,1996;AtkesonandKehoe,1999;Finn,2000).However,

thelatterstudiesdonotappeartohavemuchempiricalsupport.

Demand-side channel

According to another branch of the literature, a keymechanism whereby oil price fluctuations affect theeconomy is through a reduction in consumers’ andfirms’ spending. This view is consistent with evidencefrom recent surveys (Hamilton, 2009b) and industrysources(LeeandNi,2002).Energypricechangeshavedirecteffectsonprivateexpenditure.83Theeffectsonconsumption and investment expenditures all imply areduction in aggregate demand in response tounanticipatedenergypriceincreases.Recentempiricalevidence confirms the predominance of such demandeffectsoverthesupply-sidechannel.84

Monetary-policy channel

Monetarypolicyisanotherchannelthatmayamplifytheeffectsofoilpricefluctuationsontherealeconomy.Acentral bank, when faced with potential or actualinflationarypressurestriggeredbyoilpriceshocks,mayrespondbyraisinginterestrates,therebyexacerbatingthe drop in real output associated with rising energyprices.Theextenttowhichmonetarypolicycontributestothedropinrealoutputfollowingariseinthepriceofoil has been estimated using a range of econometricmodels (Bernankeetal.,1997;HamiltonandHerrera,2004; Leduc and Sill, 2004; Carlstrom and Fuerst,2006). However, the various estimates obtained fromthesestudiesaresensitivetomodelspecification,andthusthereliabilityofresultsremainsquestionable.Inarecentstudy,KilianandLewis(2009)findnoevidencethatmonetarypolicyresponsestooilpriceshockswereto blame for the recessions of the 1970s and early1980s.

(d) Summaryandpolicylinkages

This sub-section has presented the causes andconsequences of price volatility in natural resources,focussing particularly on the most recent commodityboomandbust.

Commoditypricechangesareinfluencedbyamultitudeof factors that work simultaneously. Economicfundamentals, such as a levelling out of productioncapacities, linkages across commodities, effectivedollardepreciationandstrongdemandfromemergingeconomies, are important factors in explaining therecent commodities boom. Similarly, marketfundamentalssuchasslowerincomegrowthduetotherecent financial crisis and the build-up of supplycapacityfollowingthelongboomperiodareimportantfactors in explaining the sharp decline in commoditypricesinmid-2008.Intheshort-run,thissharpdeclinemay also have been attributable to forward-lookingexpectationsofslowergrowthasunderlyingsupplyanddemand conditions are unlikely to have changedinstantaneously. In the long-run, the extent to whichdemand slows down and supply catches up with


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demand will depend on population growth, globaleconomicgrowth,tradepolicies,technologicalchange,andotherfactorssuchasclimatechange(WorldBank,2009).

Fromtherecentcommodityboomandbustcycle,ithasalso become clear that excessive price volatility inenergy and other essential natural resources cangenerate important transfers of income within andbetween countries. Impacts have been particularlylarge among poor urban populations and in countrieswith fewer domestic alternatives to those energy andfood items whose prices increased the most (WorldBank,2009).Withcertaincommoditiesbeingvital forthewell-beingofmanypoorpeoplearoundtheworld,apossiblerole(evenifnotthemaincause)oftradersnotconnectedtothecommoditybusinessinbringingaboutpricevolatilityhasbeenamatterofconcern.Thesocialunrest provoked by these developments led certaincountries to adopt extreme measures, such as exportprohibitions.Despite their immediateprice-dampeningeffect at home, such measures are likely to haveexacerbatedandprolongedhighmarketprices,notablybyreducingincentivestoincreaseproduction.

These events have fed into at least two importantdebatesontheneedforinternationalpolicycoordination.First, there is thequestionof the relationshipbetweenexport measures and global commodity price volatility(seeSectionD).Second,theneedtoaddressproblemsof price volatility at their source has been highlighted,notably by appropriately regulating financial markets.This includes, for instance, a discussion of betterreporting and registration requirements of OTCcommodity derivatives trading in order to improvetransparency and thus pricing efficiency in thesemarkets(Paceetal.,2008).QuestionsontheneedforfurtherinternationalpolicycoordinationandcooperationinthefieldoftradewillbefurtherdiscussedinSectionE.

7. Conclusions

Understanding the effects of trade opening on theexploitation of natural resources requires a dynamicapproachthattakesintoaccountthetrade-offbetweenextraction today and extraction tomorrow. Thissignificantly complicates the economic analysis innatural resource markets. As a result, economicliteratureonnaturalresourcesisfragmentedanddoesnotprovideacomprehensiveaccountoftheeffectsoftrade on the allocation of the resources and on theirlong-runsustainability.

Existing trade theory of natural resources shows thatthetraditionalpredictionthattradereflectscomparativeadvantage also holds when the specific feature thatnaturalresourcesareexhaustibleisexplicitlytakenintoaccount. However, traditional assumptions about theoverall gains from trade hold true only under certainassumptions,suchastheabsenceofexternalitiesandimperfect competition. Such market failures areempiricallyrelevant innaturalresourcesectors,whosemarketshavebeenoftencharacterizedbyvariousforms

ofmarketpower(e.g.cartels),weakpropertyrightsandenvironmental externalities. The dominance of naturalresources in certain countries’ economies and theprevalenceofhighpricevolatilityalsoplacelimitationson traditional expectations regarding the gains fromtrade.

First, when the imperfectly competitive structure ofsome natural resource markets is taken into account,economictheorypredictsthat,ingeneral,resourceswillbedepletedmoreslowlythanunderperfectcompetition.However, the existing literature does not provide anaccountoftheextenttowhichtheseresultsholdtrueinamoregeneralmodeloftrade,withcountriesendowedwith different types of natural resources. Nor does itexplaintheimpactofthismorecomplexglobalmarketonthegainsfromtrade.

Second,whentheopenaccessproblemassociatedwithweakpropertyrightsistakenintoaccount,someofthestandard predictions from the theory of internationaltrade about the patterns of trade and the gains fromtrademaybereversed.Whenpropertyrightsarepoorlydefined,trademayexacerbatetheproblemofresourceover-exploitation and make the resource-exportingcountryworseoff.However,thisisnottheonlypossibleoutcome. The final result will depend on the specificstructure of demand, population pressures andharvestingtechnologies.Moreimportantly,trademaybebeneficialintermsofhelpingtostrengthenacountry’spropertyrightsregime.Oneimportantsituationthattheexisting literature does not address is when naturalresources are shared by two or more countries – asituationwhereopenaccessproblemsaremostacute.

Third,trademaynotnecessarilygenerateoverallgainswhen the negative effects of extraction of naturalresourceson theenvironmentare taken intoaccount.For example, opening up to trade can exacerbate ormitigate the common pool problem depending on therelationshipbetweenspecies(thatis,whetherthestockof twospeciesaremutuallybeneficialorone reducesthesurvivalproductivityoftheother)andonthenumberof countries involved. Although economic models thatstudy the environmental effects of the extraction anduseofnon-renewableresourcesdonotgenerally lookattheimpactoftrade,tradecanhaveapositiveimpactontheenvironmentifitisassociatedtothetransferofemission-reducing technologies or access it allows toalternative(lessenvironmentallydamaging)resources.

Fourth,whenexamining thedominanceof thenaturalresourcessectorincertaineconomies,existingstudiesaredividedonwhetherresourceabundancetranslatesintofasterorslowereconomicgrowth.Somestresstherisks of over-specialization in the resources sector,including de-industrialization (the so-called Dutchdisease), problems associated with excessive pricevolatility,economic instabilityandcivilconflict.Others,however, point to examples of economies that havesuccessfully harnessed resource specialization foreconomic growth, and conclude that other factors,besides resource endowments, are key predictors ofeconomicsuccessorfailure.


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Finally,studiesexaminingthecausesandtheeffectsofhigh price volatility in natural resource markets haveemphasizedthetwo-wayrelationshipbetweenvolatilityand trade. On the one hand, trade allows for a moreefficientdiversificationof inputsources,thusreducingthesensitivityofnaturalresourcepricestocommodity-specificshocks.On theotherhand, volatilitymayalsoadversely influence countries’ openness to trade(triggeringexport-restrictingpolicy responses)orhowthey trade (e.g. organized exchanges versus bilateral

long-term contracts). The literature also stressesthe important role that commodity-based financialinstrumentsmayhaveinprovidingahedgemechanismagainsttheriskofvolatilityorincontributingtosuddenpriceswingsviaherdingeffects.Oneweaknessoftheliteratureisthatitfocusesmainlyonoilpricemovements.Whilesomeofthe insightsmaybeapplicabletoothercommodities,theabsenceofstudiesonthecausesandconsequencesofvolatility inother resourcesectors isregrettable.

Endnotes1 SeeWTO(2008)foradiscussionoftheseextensions.

2 Theopportunitycostofdepletionisalsoknownasuser-cost,insitu-valueorresource-rent.

3 ThelistofextensionsoftheHotellingmodelisnotanexhaustiveone.Forrecentsurveysofthetheoreticalandempiricalliteratureonnon-renewableresourceeconomics,seeLivernois(2009)andKrautkramer(1998).

4 Someunderlyingassumptionsarebuiltintothemodels.First,eachcountryissmallrelativetoworldmarketsandisabletosellandbuyatagivenandconstanttermsoftrade.Second,markets are perfectly competitive. Third, no economic orpolitical distortion exists: a social planner chooses theallocationofresourcestomaximizepresentandfuturesocialwelfare(i.e.thepresentdiscountedvalueoftheflowoffutureutilities).

5 TheonlydeparturefromtheHeckscher-Ohlintheory(underthe“Hybrid”scenario)isthataneconomywouldobviouslyswitchitsspecializationfromonecommoditytoanotherwhentherateofresourceextractiondeclinestozeroanditsinitialcomparativeadvantagedisappears.

6 TheseissueswillbeaddressedinSectionsC.3andC.4.

7 Fixedcostsarethosethatfirmshavetopayforcertaingoodsorservicesindependentlyofhowmuchtheyultimatelyproduce.Astheoveralllevelofoutputrises,thefixedcostsgetdistributedoveralargernumberofunits,and,hence,thefirm’saveragecostsofproductiondecline.

8 Inparticular,theoreticalliteraturehasfollowedtwoapproachestomodelapartiallycartelizedindustrywithacompetitivefringe.SomehavemodelledmarketcompetitionasaCournot-Nashequilibrium,inwhicheachproducerisassumedtochooseoutputtomaximizeitsownprofits,takingasgiventheproductionschedulesoftheothers(Salant,1976;Pindyck,1978;UlphandFolie,1980;LewisandSchmalensee,1980).Othershavetreatedthecartelasadominantfirminaso-calledStackelberggame,inwhichthecartelactsasaleader.Thecompetitivefringewillhavetoacceptthepricefixedbythecartel,butthecartelwillhavetofixthepricetakingintoaccounttheoutputproducedbythecompetitiveproducers(Gilbert,1978;Newbery,1981;Ulph,1982;Grootetal.,1992;Grootetal.,2003).

9 ForadiscussiononthepossibleroleofforwardtradingontheallocationofresourcesunderimperfectcompetitionseeLiskiandMontero(2008).

10 Ateachmomentintimepriceswillexceedmarginalcostsbyamarkup.Thismarkupwilldependon(isthereciprocalof)thepriceelasticityofdemand.Inparticular,themorerigidworlddemand,thehigherthecartelmarkup.

11 InthesimplermodelconsideredbyHotelling,marginalcostsarenegligible.Whentheyarenot,theHotellingruleisintermsofprices(foraperfectlycompetitiveeconomy)andmarginalrevenue(foramonopoly) netofmarginalcosts.

12 Economictheoryhasshownthatintheabsenceofmethodstoenforcelong-termcommitments,timeconsistentequilibriaexistunderasetofverylimitedconditions(Newbery,1981;UlphandFolie,1980;MaskinandNewbery,1990).

13 RecallthattheHecksher-Ohlintheoremonlyexplainsinter-industrytrade,thatistheexchangeofdifferentgoodsbetweentwodifferentcountries.InanHeckscher-Ohlinframeworktradetakesplacebecausecountriesaredifferent,thereforethereisnoreasonforcountriestoexchangeidenticalgoods.

14 Two-waytradeinhorizontallydifferentiatedgoodsisexplainedineconomictheorybytheso-called“new”tradetheory.Inthissetup,increasingreturnstoscalefavoureachcountry’sspecializationinalimitednumberofvarietiesandconsumers’loveofvarietyensuresthatforeignanddomesticvarietiesofacertainproductareconsumed.Themodelassumesthatfirmsoperateundermonopolisticcompetition.But,thisassumptionisthenecessaryconsequenceofincreasingreturnstoscale,ratherthanthedeterminantoftrade.

15 Thisdecisiondependsonwhetherthefirmperceivesitssalesintheforeignmarkettobemoreresponsivetopricereductionsthaninthedomesticmarket.

16 RefertoBlockandTaylor(2005)foranextensivereviewoftheeconomicliteratureonthelinkbetweengrowthandtheenvironment.

17 Moretechnically,iftheelasticityofsubstitutionbetweenthenon-renewableresourceandotherinputsisgreaterthanorequaltoone,andiftheelasticityofoutputwithrespecttothenaturalresourceislowerthantheelasticityofoutputwithrespecttophysicalcapital,thenitispossibletoguaranteeaconstantconsumptionpathwithagrowingpopulation(Stiglitz,1974;Solow,1974b;Solow,1974a).

18 Insomeways,theseresultsparallelthefindingsoftheliteratureonenvironmentalquality:technologicalprogresscanhaveoppositeeffectsontheenvironmentdependingonwhatsectorsareinvolved.Indeed,technologicalchangeingoodsproductionhasa“scaleeffect”thatraisesemissions,whiletechnologicalprogressintheabatementsectordrivesemissionsdownwards,throughapure“techniqueeffect”(TaylorandBrock,2005).

19 It is important to point out one limitation in the literaturereviewedinthissub-section.Thepapersallconsiderasituationwherethenaturalresourcesstockissubjecttoexploitationonlybycitizensofthecountryanddonotconsiderthecircumstancewheretheresourceissharedbytwoormorecountries.However,someof themostsevere formsofopenaccessproblemsaretransboundaryinnature,e.g.fishintheopenoceanthatarenotunder the jurisdiction of any single nation or migratory/straddlingstocks thatpassbetween jurisdictions.Acompletediscussionof transboundaryproblemsassociatedwithnaturalresourcesarefoundinSectionDonregionalagreementsandinSectionEofthisreport.


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20 Unfortunately,thiswillnotalwaysbethecase.First,theenvironmentalistmayhavethesizeofthestockcorrespondingtomaximumsustainableyieldasanobjective.Butthesizeofthenaturalresourcesstockcorrespondingtomaximumrentwillusuallybesmaller.Second,ifthediscountrateishigherthanthemaximumrateofgrowthoftheresource,theeconomicallyefficientdecisionwillbetoextinguishthestock.

21 Thegrowthfunctionis

€

dS(t)dt

= rS(t)(1−S(t)K

) ,where

€

dS(t)dt istherate

ofchangeofthestock;risthemaximumpossiblebiologicalgrowthrateoftheresource;S(t)isthesizeofthecurrentstockwhichdependsontime,andKistheenvironmentalcarryingcapacityoftheresource.Thesolutiontothisfirst-orderdifferentialequationisalogisticfunction.TherelationshipisoftencalledtheSchaefercurveafterfisheriesbiologistSchaefer(1957)whouseditextensivelyinhiswork.

22 Thesteadystateconditionisgivenby:

€

dS(t)dt

= h(E,S) where

€

h(E,S) = E * S isharvest.Harvestdependspositivelyoneffort(E)andthestockofnaturalresource(S).Usingtheserelationshipsandthegrowthrate,itispossibletosolveforthestockasafunctionofeffortandsubstitutetheresultintotheharvestequation,whichfinallygivesharvest(orrevenues)asafunctionofeffortinFigure14.

23 Usingthegrowthfunctionandthesteady-statecondition,itispossibletoshowthatthereisanegativerelationshipbetweenstockandeffortinthesteadystate.

24 Forafullerdiscussionoftheroleofthediscountrate,seechapters2and3ofClark(1990).

25 ThisfisheryislocatedintheNorthwesternPacificwatersofCanadaandtheUnitedStates.

26 GeoduckisaspeciesofverylargesaltwaterclamthatisnativetothenorthwestcoastofCanadaandtheUnitedStates.

27 Thisreportfocusesontradeinnaturalresourcesandhenceitwillnotdealwiththeliteratureanalysingtheeffectoftradeontheenvironmentwhenenvironmentalexternalitiesaremainlygeneratedintheproductionsectors(e.g.industrialpollution).ForadescriptionandanalysisofthisliteratureseeWTO-UNEP(2009).

28 Thisclassificationisalsovalidforrenewableresources.Anexampleofflowexternalitiesisforestharvesting.Thestockexternalityofthisactivityinvolvesdeforestation,soilerosion,speciesextinction,andanincreasedconcentrationofcarbonintheatmosphere.

29 WhilemodelssuchasSinclair(1994),UlphandUlph(1994),Withagen(1994),HoelandKverndokk(1996),KolstadandKrautkraemer(1993),Babuetal.(1997)andWelshandStähler(1990)considertheexternalitiesinapartialequilibriumframework,Stollery(1998),Schou(2000)and(2002),GrimaudandRougé(2005)and(2008),GrothandSchou(2007)andAcemogluetal.(2009)usegeneralequilibriummodels.

30 ForadiscussionoftheHotellingruleseeSectionC.1.

31 Datashowthat87percentoftotalconsumptionofenergyin2000wasrepresentedbyfossilfuelssuchasoil(40percent),coal(25.7percent)andnaturalgas(22percent).SeeKronenberg(2008).

32 TheconceptofbackstoptechnologywasfirstintroducedbyNordhaus(1974)andreferstoanalternativewayofproducingacertainoutputwhichdoesnotrelyonexhaustibleresources.Examplesinthecontextofelectricitygenerationaresolarorwindenergy.

33 OPECcountriesalsohaveanincentivetoboosttheirreserveestimates,becausetheirexportquotasdependonthetotalamountofreservestheyhave.SeeCampbellandLaherrère(1998).

34 SeeforinstanceKrautkramer(1998).

35 Itisassumedthattheprobabilityofanewdiscoveryisdecreasingovertime.

36 Thistechnologicaloptionhascurrentlybecomepromisingforthefossilenergyextractionindustry.Infact,thepossibilityandviabilityofcapturingandsequesteringsomefractionofthecarbondioxidearisingfromfossilfuelcombustionhasbeenrecentlydemonstrated.Thisprocess,oftenlabelledasCO2captureandstorage(CCS),consistsofseparatingthecarbondioxidefromotherfluxgasesduringtheprocessofenergyproduction;oncecaptured,thegasesarethendisposedintovariousreservoirs.

37 Whilethecombustionofnaturalgasreleases117,000poundsperbillionbtuofenergyinput(p/btu)ofcarbondioxide,92p/btuofnitrogenoxidesand1p/btuofsulfurdioxides,burningoilandcoalproducesrespectively164,000and208,000p/btuofcarbondioxide,448and457p/btuofnitrogenoxidesand1,122and2,591p/btuofsulfurdioxides,seeIEA(1998).

38 AccordingtoBarbierandRauscher(1994)andSwallow(1990)habitatdestructionisoneoftheobstaclestothelong-runviabilityofmorethan50percentofthosespeciescurrentlythreatenedbyextinction.

39 BarbierandSchulz(1997),Smuldersetal.(2004)andPolaskyetal.(2004)illustratetheeffectoftradeinnaturalresourcesonbiodiversitythroughtheeffectonnaturalhabitat.Brocketal.(2007)analysetheeffectoftrade-inducedbiologicalinvasiononbiodiversity.

40 Herethediscussionwillberestrictedtoidenticalcountries.Ingeneralhowever,theliteraturetakesintoaccountthefactthatcountriesdifferinsize,productivityandtastesandshowsthatinthesecases,theeffectoftradeopeningonbiodiversityisnotclearandwilldependonmultiplefactorssuchasthesectorsinwhichthecountrieswillspecialize,therelativesizeofthespecieshabitatacrosscountriesordifferencesintheeco-systemsacrosscountries.

41 Thisdescriptionof“species-habitatarea”curvecomesfromMacArthurandWilson(1967)andiswidelyusedinecologicaltheory.

42 SeePolaskyetal.(2004).

43 Thewelfareeffectsoftradedependonhowbiodiversityaffectstheutilityofconsumers.Consider,forexample,thatacertainspeciesprovidesservicestothepopulation.Theimpactoftradeonwelfarewilldependonwhetherthespecieshastobelocatedinthesamecountryoftheconsumer(e.g.speciesofsedges,whichareprimarilyusedtofilterwaterinwetlandecosystems)toprovideapositiveeffectonitsutility,orwhetherthelocationofthespeciesisnotrelevant(e.g.speciessuchaschimpanzeesforwhichpeoplecarethattheworldwidepopulationdoesnotbecomeextinct).

44 However,resultscanbeextendedtoothernaturalresourcessuchasforestryandhuntingofwildanimals.

45 Whencountrieshavemarketpowerandtastesareidenticalthepriceeffectwilloffsetthebiologicalexternalityandanefficientlevelofharvestingwillbereached.

46 Resourceconcentrationisasufficient,butnotnecessaryconditionforconcentratedtradepatterns.The“newtradetheory”allowsforextremeconcentrationevenwhereendowmentsaresimilaracrosscountries.Moreover,evenifitwasthegeographicaldistributionoffactorendowmentsthatledtothesetradepatterns,extremetradeconcentrationcouldbetheresultofgeographicallyconcentratedcapital,orskilledlabour.Forthesakeoftheargumentsputforthinthissection,itsufficestonotethattradeinresourcesisapredominantshareofproductionandexportactivitiesinafewabundantcountries,regardlessoftheunderlyingreason.

47 Thetermwascoinedin1977byThe EconomisttodescribethedeclineofthemanufacturingsectorintheNetherlandsafterthediscoveryofalargenaturalgasfieldin1959.


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48 SeeCordenandNeary(1982)andCorden(1984).

49 Itmightbethecasethatthenaturalresourcesectordoesnotemployafactorthatismobileacrosssectors,andiseffectivelyanenclaveintheeconomy.Inthissituationthereisonlyaspendingeffect,becausethereisnointersectoralreallocationofproductiveresources.

50 Figure16isfromSachsandWarner(1995).

51 Afewcaveatsareinorder.First,theexistenceofexternaleconomiesinthemanufacturingsectorhasnotyetbeendetermined.SachsandWarner(1995)themselvesstatethat“thelinksoftheseDutchDiseaseeffectstothelossofproductionexternalities,however,remainsspeculativeandasyetunproven”.Second,thepresenceofexternaleconomiesjustifiesgovernmentsubsidizationofthegrowth-drivingsector.ThelowergrowthpathBCDofFigure16maythenbeduetogovernmentfailureratherthantotheresourceboomper se.Third,thesamegrowthpathBCDcouldbeduetoresourcedepletion,which–asshownamongothersbyNordhaus(1992)andBoyceandEmery(2006)–isadragoneconomicgrowthwhenitisnotoffsetbytechnologicalprogress.Fourth,AlexeevandConrad(2009),whostudytheeffectofoilabundanceonGDPlevels,havenotdeterminedanyresourceextractingeconomytobeonpartCDofFigure16.TheyareallonpartBC,anditisnotknownwhetherCDwillhappen.

52 BytheRybczynskitheorem,thenon-traded,capitalintensivesectorexpandsandthetradedsectorcontracts;theresultingincreaseintherelativesupplyofnon-tradedgoodscausesadepreciationoftherealexchangerate.OthercasesarediscussedinVanderPloeg(2006).

53 Collieretal.(2009)noticethatthisisatheoreticalpossibility.Inpractice,however,eveninthepresenceofunder-employedresources,supplyresponsesaredampened,producinghigherwagesandahigherpriceofdomesticoutputasawholerelativetothepriceofforeigngoods,thereforearealappreciationofthecurrency.

54 BrunstadandDyrstad(1992)findthatoccupationalgroupsinareasclosetotheboomingsectorwhichdidnotexperiencepositivedemandeffectsexperiencedadecreaseintheirrealwagesasaresultofthepetroleumboom.

55 SachsandWarner(1995)alsoshowthatresource-intensiveeconomieshadahigherratioofoutputofservicestooutputofmanufactures.ThisisconsistentwiththepredictionoftheDutchdiseasemodelsthattheratioofnon-tradedto(non-resource)tradedoutputwillbehigherinresourceintensiveeconomies,totheextentthatservicesproxythenon-tradedsectorandmanufacturesproxythenon-resourcetradedsector.

56 Whenthereismorepoliticalcompetition,ontheotherhand,thegovernmentwouldtrytoretainitspowerandtherebyitmightbeforcedtospendmoreonprovisionofpublicgoodstopromotegrowth.BhattacharyyaandHodler(2009)makeasimilarpointbyarguingthattherelationshipbetweennaturalresourceabundanceandcorruptiondependsonthequalityofthedemocraticinstitutions:resourceabundanceispositivelyassociatedwithcorruptiononlyincountrieswithlownetdemocracyscore.

57 Thereisapotentialendogeneityconcern,namelyreversecausalityfromeconomicgrowthtoresourceendowment.SachsandWarner(1995)arguethattherelationshipisrobusttotheintroductionofanalternativemeasureofnaturalresourceabundance–arablelandareatopopulation–whichisrelativelylessendogenousthantheratioofnaturalresourceexportstoGDP.

58 Fortheperiod1970-98,theyestimateagrowthregressionincludinginstitutionalqualityandnaturalresourceabundanceinthesetofexplanatoryvariables.Institutionsareinstrumentedwithvariablesthatdonotaffectgrowthbetween1970and1998–namelymortalityratesofcolonialsettlers,asinAcemogluetal.(2001)andfractionofthepopulationspeakingEnglishandEuropeanlanguages,asin

HallandJones(1999).Thefirst-stageregressionresultsallowonetotesttheindirecteffectofnaturalresourcesongrowthviatheirimpactoninstitutionalquality.

59 Theinclusionoflevels,ratherthangrowthrates,ofpercapitaGDPisjustifiedbyobservingthatifacountryhasahigherpercapitaGDPthananother,itmusthaveexperiencedfastergrowthoverthelongtermthantheother.

60 Forsimilarreasons,conflictismorelikelyforcapital-intensiveresourcesthanforlabour-intensiveones(DubeandVargas,2006).

61 Sincetheyinducerent-seeking,point-sourceresourceswillalsotendtodeteriorateinstitutions(andthereforegrowth),beyondtheireffectonthelikelihoodofconflict.Thisisconfirmedbytheempiricalliterature.Forinstance,Ishametal.(2003)showthatexportconcentrationinpoint-sourcenaturalresourcesandplantationcropsisstronglylinkedtoweakpublicinstitutionsandgovernanceindicatorswhich,inturn,generatelowercapacitytorespondtoshocksand,ultimately,lowereconomicgrowth–ascomparedwithmorediffusenaturalresourcessuchasagriculturalproducts.Therefore,itseemsthatthetypeofnaturalresourceexportsisacrucialdeterminantofwhethernaturalresourcesbecomeacurseorablessing(forastudybasedonpaneldataeconometricmodeling,seeMurshed,2004).

62 Secessionistconflictreferstowarstartedwiththeaimofsplittinguparegionofthecountryandfoundinganautonomousstate,whilecentristconflictisaboutgainingthecontrolofthewholecountry.

63 FismanandMiguel(2008)proposeshiftingsomeamountofinternationaldevelopmentassistanceawayfromlong-terminvestmentandtowardshort-termemergencyaidforcountrieshard-hitbyacollapseinpricesoflabour-intensivecommoditiessuchascoffee.Thisaidwouldkickinassoonaspricesfall,potentiallyavoidingtheoccurrenceofviolentconflict.

64 SeealsoRoss(2004).

65 AnearliercomparativeanalysisbyDavis(1995)alsofoundnoevidenceofaresourcecurse;theobservedmineraleconomieshaddonewellinanumberofdevelopmentindicatorsagainstnon-mineraleconomiesoverthesameperiod,evenoutperformedtheminsomecases.

66 Arelatedidea,exploredinRodriguezandSachs(1999),isthatwithconstantordecliningresourceproductionandexogenousgrowth,GDPpercapitaasymptoticallyapproachesthatofanon-mineraleconomyfromabove,thusexhibitingnegativegrowthrateduringthetransitiontosteadystate.

67 AccordingtoKilian(2009a),thisinterpretationishowevernotentirelyconsistentwithawiderangeofevidencethatindicatesacentralroleforoildemandshocksinallpreviousoilpriceshockepisodessince1972,excepttheoilpriceshocktriggeredbytheoutbreakoftheIran-IraqWarinlate1980.

68 Thisisassociatedwiththeideaofa“randomwalk”,whichisatermlooselyusedinthefinanceliteraturetocharacterizeapriceserieswhereallsubsequentpricechangesrepresentrandomdeparturesfrompreviousprices.Itimpliesthatexpertsinthefieldcannotsystematicallyoutperformuninformedinvestors,exceptthroughluck.

69 Theideaof“herding”infinancialmarketsmaybetracedbacktoKeynes’sBeautyContestwherehedescribedthebehaviourofmarketparticipantsusingananalogybasedonafictionalnewspapercontest.Hearguedthatinvestorsinequitymarketsanticipatewhataverageopinionexpectsaverageopiniontobe,ratherthanfocusingonthingsfundamentaltothemarket(Keynes,1936).

70 Theseareinvestorswhodistributetheirwealthacrosskeycommodityfuturesaccordingtopopularindices,suchasStandard&Poor’sorGoldmanSachsCommodityIndex.


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71 Commoditiesprovidediversificationtoaninvestmentportfolioforatleasttworeasons.First,commoditiesaresubjecttofactors,suchasweatherconditionsorminers’strikes,thathavelittleornothingtodowithexpectationsaboutstockorbondmarkets.Second,iftherewere,forinstance,widelyheldbeliefsaboutrisinginflation,bondpriceswouldfallasinterestratesriseandstockmarketsmightbenegativelyaffectedaswell.However,sincecommodityinvestmentsreflectexpectationsaboutfurtherpriceincreasesover“real”products,theirpricesshouldbeexpectedtorisealongwithexpectationsabouthigherinflation(Greer,2005).

72 Inotherwords,therealinterestratecouldbenegative.

73 Ithasbeenarguedthatasspeculatorsdrivecommodityfuturespriceshigher,theeffectsarefeltinspotmarketsandtherealeconomy,sincespotmarketparticipantstypicallybasetheirsupplyanddemanddecisions,atleastinpart,onexpectedpricechangesinthefuture(Masters,2008;Hamilton,2008).

74 ‘Swapdealers”whoprovidetrades,whichcatertotheneedsofcommercialentities,accountforthebalance.

75 Thespeechcanbeaccessedat:http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178

76 Moreprecisely,HausmannandRigobon(2003)showthata1standarddeviationshocktothepriceofoilrepresentsanincomeshockequivalentto6percentofGDP.

77 HausmannandRigobon(2003)makethefollowingexample:Assuminganeconomywhereoilaccountsfor30percentofnationalincomeandhasastandarddeviationofabout30percentperyearandgivenaconstantrelativeriskaversion(CRRA)utilityfunctionwitharelativelyhighriskaversioncoefficientof3,atypicalconsumerwouldbewillingtosacrifice4.05percentofnationalincomeinordertomakeoilrevenuesperfectlycertain.

78 Sincetheoilproducers’abilitytoabsorbinfusionsofcapitalislikelytobelimited,theyinevitablyinvesttherevenuethatcannotbeinvesteddomesticallyinoil-importingeconomies.Agoodexampleisthesovereignwealthfundsmaintainedbymanyoil-producingcountries(Kilian,2009c).Becauseofthistransferoffinancialwealthfromoilexporterstooilimporters,positiveoildemandshocksornegativeoilsupplyshocksshouldbeassociatedwithatemporarycapitalgaininoilimportingcountries.Thisistheso-called“valuationchannel”oftransmissionofoilpriceshocksacrosscountries.Another,realchanneloftransmissionofoilpriceshocksacrosscountriesisthe“tradechannel”,whichworksthroughchangesinthequantitiesandpricesofgoods

exportedandimported,andisreflectedintheresponseofthetradebalance.Kilian(2009c)explainsthatsupplydisruptions,byincreasingthepriceofoil,causeasurplusintheoiltradebalanceandadeficitinthenon-oiltradebalance(netexportsofnon-oilproducts)oftheexporter.Byconstruction,theresponseintheimportingeconomywillbethemirrorimageofthatoftheexportingeconomy.Demandshocks–associatedforinstancewithproductivityimprovementsintheoil-importingcountrythatraisedemandnotonlyforcrudeoil,butforallotherindustrialcommoditiesaswell–havetwoopposingeffects.Ontheonehand,theyraisethepriceofoil,causingasurplusoftheoiltradebalanceandadeficitinthenon-oiltradebalanceoftheexporter.Ontheotherhand,theyrepresentashort-runstimulusfortheoil-importingeconomy,whichwilltendtocauseanon-oiltradesurplusfortheexporter.EmpiricalresearchbyKilian(2009b)andKilianandPark(2009)ontheUSeconomy(netoilimporter)suggeststhatthelattereffectdominatesintheshortrun,whiletheformereffectdominatesafteroneyear.

79 SeeSectionC.4foradiscussionofotherchannelsofthenaturalresourcecurse.

80 See,amongothers,Aghionetal.(2009)andRameyandRamey(1995).

81 Theauthorsdevelopatheoreticalmodelshowingthatvolatilityinnaturalresourcerevenues,inducedbyvolatilityinprimarycommodityprices,curbsgrowthineconomieswithpoorlyfunctioningfinancialsystems.ThispredictionissimilartoHausmannandRigobon(2003).

82 BlanchardandGali(2007).Sincethelate1980s,however,theeffectsofrealoilpriceshocksonoilimportingcountrieshavebeensignificantlysmaller.ThisisdiscussedinBox12.

83 Thisoccursthroughfourmechanisms:(i)thediscretionaryincomeeffect,thatreferstothereductioninincomeavailablefornon-essentialspendingbroughtaboutbyhigherenergyprices,asconsumershavelessmoneytospendafterpayingtheirenergybills;(ii)theuncertaintyeffect,thatreferstothepostponementofirreversiblepurchasesofconsumerdurables,aschangingenergypricesmaycreateuncertaintyaboutthefuturepathofthepriceofenergy;(iii)theprecautionarysavingeffect,thatreferstotheincreaseintheuncertainty-relatedcomponentofsavings,andtheconsequentfallinconsumption,inresponsetoenergypriceshocks;(iv)theoperatingcostseffect,thatreferstothedelayedorforegonepurchasingofenergy-intensivedurables,whoseconsumptionwilltendtodeclineevenmorethanconsumptiononothergoods.

84 SeeHamilton(2008)andKilianandPark(2009).

C. Trade theory and natural resources - World Trade Organization

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