Presented By: Ankit Jaini (Y8087) Supervisor: Dr. Somesh K. Mathur ECO 231
Through this paper I plan to re-examine Lucas’s famous question, “Why doesn’t capital flow from rich countries to poor countries?” in the wake of the explosion of “emerging markets” investment over the past decade and also look into patterns of foreign investment. Although more of a subjective analysis rather than an empirical one, I have tried to include a bit of quantitative estimation too in the paper with the hope of sufficiently describing and portraying my understanding of the paradox.
Standard economic theory tells us that financial capital should, on net, flow from richer to poorer countries. That is, it should flow from countries that have more physical capital per worker—and hence where the returns to capital are lower-to those that have relatively less capital-and hence greater unexploited investment opportunities. In principle, this movement of capital should make poorer countries better off by giving them access to more financial resources. As financial globalization increases, these flows from industrial to developing countries will increase, making all countries better off. This would seem an ideal situation, but what is the reality? In a famous article written in 1990, Robert Lucas pointed out that capital flows from rich to poor countries were very modest, and nowhere near the levels predicted by theory. Financial globalization has surged in the past decade and a half. While cross-border capital flows worldwide have risen substantially, reaching nearly $6 trillion in 2004, less than 10 percent of them go to developing countries. What then has become of the empirical paradox that Lucas identified? Has increasing financial integration resolved it?
The Chart on the next page shows the less availability of capital for the poor countries.
*source: World Development Indicator database (World Bank)
Review of Literature
The only main literature I referred to was the original paper by Lucas (1990). Lucas (1990): Using a one-sector model, Lucas (1990) suggested that it was a paradox that more capital does not flow from rich to poor countries. His reasoning goes as follows. Let y = f (L, K)
be the production function where y is the output produced using labour L and capital K. Let ‘p’ be the price of goods, and ‘w’ and ‘r’ be returns to labour and capital, respectively. Firm’s profit maximization problem gives:
r = p∂f (L, K)/∂K = p∂f (1, K/L)/∂K
With free trade, the price of goods is equalized across countries. The Law of Diminishing Marginal Product implies that ‘r’ is higher in the country with lower per capita capital. As an illustration, Lucas calculated that the return to capital in India should be 58 times as high as that in the United States. Facing a return differential of this magnitude, Lucas argued, we should observe massive capital flows from rich to poor countries. That it does not happen has come to be known as the Lucas paradox. Lucas (1990) discussed three possible explanations:
1. A worker in a rich country could be several times more productive than her counterpart in a poor country. 2.Human capital may be a missing factor and is likely much higher in a rich country. 3.Political risk and hence required risk premium may be substantially higher in a poor country.
Examining the paradox
In my perspective besides the three explanations given by Lucas, the main theoretical explanations for the Lucas paradox can be grouped into two categories. The first group of explanations includes differences in fundamentals that affect the production structure of the economy. These can be omitted factors of production, government policies, and institutions. All of these affect the marginal product of capital via...