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This paper investigates how a country's specific-factor endowment affects its long-run economic performance. We build an open-economy version of the two-sector neoclassical growth model in which we introduce fixed industry-specific inputs in both activities. We show that differences in input shares between sectors can contribute to explain why nations that seem to have similar factor endowments can show very different income levels. In particular, under (productivity-adjusted) factor-price equalization, larger amounts of factors specific to the industry with a lower (larger) labor share lead the economy to enjoy larger (smaller) long-run income levels. The model can also account for overtaking episodes between countries along their development paths.

This paper introduces fixed specific factors into an open-economy version of the standard two-sector neoclassical growth model. The main contribution of the paper is to provide conditions under which a larger endowment of an industry-specific factor has negative effects and conditions under which it has positive effects on a country's long-run income level. The paper can therefore explain why some nations that seem to have similar endowments can show very different income levels. Our hypothesis is that one source of this difference can lie in the input intensities displayed by the industries to which these factors are specific. The importance of industry-specific factors has been recognized at least since the work of Ricardo (1817).1 However, their impact on long-run income and growth is not yet well understood. To illustrate this, take the example of a very important set of specific factors: natural resources. These include land in agriculture, large bodies of water and coal in energy generation, and all kinds of minerals in their respective extractive industries. There is puzzling empirical evidence on the relationship between the natural-resource endowment and a nation's economic performance. On one hand, we observe that large factor endowments can sometimes be a curse in terms of income. For instance, in the past, there have been resource-poor economies such as the Netherlands and Japan that have outperformed resource-rich nations such as Spain and Russia. Nowadays, most Asian tigers are resource-poor, whereas growth losers such as Nigeria, Zambia, Sierra Leone, and Venezuela are resource-rich. Gylfason (2001) and Sachs and Warner (2001) also argue that resource abundant countries lag, on average, behind countries with less resources. On the other hand, natural-input abundance seems to be a blessing some other times. World Bank (1994) finds at least five nations that belong to both the top eight regarding natural capital wealth and the top fifteen regarding per capita income. Solving this puzzle is important for several developing countries, such as the ones in the middle East and Latin America, where the discovery of natural resources has been considered as a positive precondition for more growth. We study a world economy that has the production structure of the two-sector neoclassical growth model with consumption and investment goods, in the tradition of Oniki and Uzawa (1965), in which the different industries have different input intensities. Firms in both sectors employ product-specific factors. An alternative technology also allows producing investment goods using only mobile resources. Population is constant and consists of identical infinitely lived agents. There exists as well in the model a small-open economy that shares preferences and technologies with the rest of the world, but can have different specific-factor endowments. The paper shows that larger amounts of inputs that are specific to an activity with a relatively large capital share lead the small nation to enjoy higher long-run welfare levels. On the contrary, larger stocks of factors that are specific to the less capital-intensive sector have a negative influence on capital accumulation. This negative influence totally offsets the positive effect of the larger specific-factor endowment and leads the economy to permanently lower income levels if the labor share of the technology to which this input is specific is sufficiently larger than the one of the technology that frees labor as a consequence of the increase in the specific factor. The negative effect, on the other hand, disappears if the small country specializes in the production of one good. Under specialization, a larger endowment always raises long-run capital and output. The model predicts as well overtaking episodes between small-open economies along their development paths. The concern on the possibility of negative real income effects arising from an augmented resource is an old issue in development economics. The literature has already identified at least two channels through which an increase in a specific factor affects the allocation of resources and lead to a decrease in income. The first one operates through changes in international prices. In particular, the extensive literature on immiserizing growth or on the structural problems arising from a discovery of a natural resource (the called ‘Dutch disease’) shows that the possibility of a negative effect on income arises when either the terms of trade deteriorate or the real exchange rate worsens.2 This effect is ruled out in our model because the terms of trade of our small economy do not depend on domestic endowments. Second, there can be a technology channel that operates through differences in the overall efficiency level. For example, Matsuyama (1992) and Galor and Mountford (2003) emphasize that a larger natural endowment reduces the incentives to allocate resources to more growth-enhancing activities such as manufacturing and education, and therefore decreases long-run output. This mechanism is also absent in our model given that technological change is factor neutral and sector neutral. Here, we point to the relevance of a third channel, driven by the small-open economy assumption. Specific factors create differences in total factor productivity (TFP) across nations. Thus, ceteris paribus, a country with a higher level of a specific factor should have a higher income per capita, because of this TFP effect. However, unlike exogenous differences in TFP, an increase in a specific factor reallocates capital and labor from the rest of the economy to the sector to which the input is specific. This shift in resources affects the aggregate demand of labor and capital in a way that depends on input intensities. In a small-open economy for which the world's relative price is given, the latter Rybczynski effect implied by the augmented factor can reverse the positive TFP effect, and generate a lower long-run income level. 3 Our work is also related to dynamic international trade models that determine savings from utility maximization. Eaton (1987) is the first to take the Jones–Samuelson specific-factors model to a dynamic setting. He considers an OLG framework in which land (a fixed factor) is used specifically in the production of one commodity, that capital (an accumulable resource) is the specific input in the production of the other commodity, and that labor is used commonly in both production activities. As in our model, a land abundant country can have a lower steady state welfare but under different and more restrictive conditions.4Brock and Turnovsky (1993) use the same type of model as Eaton to study the impact of differential tariffs on welfare. Markusen and Manning (1993) embed the Jones–Samuelson specific-factors model into a representative-agent framework. They, however, do not analyze the effects of larger endowments on long-run income.5 The rest of the paper is organized as follows. Section 2 describes the economic environment. Section 3 studies the diversified production equilibrium of the world economy. Section 4 analyzes how the composition of the factor endowment affects the steady-state outcome of a small-open economy, both qualitative and quantitatively. Section 5 discuses the results. Section 6 concludes.

The paper has presented an open-economy version of the two-sector neoclassical growth model in which investment- and consumption-goods are produced using fixed specific factors. Our model differs from the dynamic specific-factors model of international trade in that we allow capital to move freely across sectors and have a third technology to manufacture investment goods that only requires intersectorally mobile factors. It is the inclusion of this technology what induces factor–price equalization across open economies that produce within the diversification cone. The model predicts that nations that diversify production but possess a relatively low endowment of factors can outperform countries with a larger natural-resource endowment. The reason is that a larger specific-input endowment in a less capital-intensive sector drives the economy towards a long-run allocation with a lower capital stock, which can completely offset the positive effects of the larger resource stock. Quite the contrary, if two nations only differ in their input endowment specific to a relatively capital-intensive industry, the resource-richer nation also becomes the per capita output-richer economy. Our model has also clear implications for empirical research. The above findings suggest that in order to disentangle the impact of fixed specific-factors and, in particular, natural resources on income levels and growth rates, it is important to carry out the investigation at the sectoral level.