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Lucas paradox
Economic observation that capital does not flow from rich to poor countries

In economics, the Lucas paradox highlights the unexpected lack of capital flow from developed countries to developing countries, despite the latter’s lower capital per worker. Classical economic theory suggests capital should move to poorer countries due to diminishing returns, making investment there more profitable. However, minimal capital actually flows, a puzzle first noted by Robert Lucas. Explanations include differences in production factors like technology and institutions, or market imperfections such as sovereign risk and asymmetric information, which increase uncertainty and hinder investment despite high expected returns.

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Example: development of Third World nations

Lucas’ seminal paper was a reaction to observed trends in international development efforts during the 20th century. Regions characterized by poverty, such as South Asia and Africa, have received particular attention with regard to the underinvestment predicted by Lucas. African nations, with their impoverished populace and rich natural resources, has been upheld as exemplifying the type of nations that would, under neoclassical assumptions, be able to offer extremely high returns to capital. The meager foreign capital African nations receive outside of the charity of multinational corporations reveals the extent to which Lucas captured the realities of today’s global capital flows.3

Authors more recently have focused their explanations for the paradox on Lucas’ first category of explanation, the difference in fundamentals of the production structure. Some have pointed to the quality of institutions as the key determinant of capital inflows to poorer nations.4 As evidence for the central role played by institutional stability, it has been shown that the amount of foreign direct investment a country receives is highly correlated to the strength of infrastructure and the stability of government in that country.5

In many cases in Armenia, the Lucas paradox is confirmed․ Ineffective implementation of legal and legislative mechanisms, insufficient level of development of the financial sector, and ineffective allocation of high-quality human capital are possible reasons behind the low inflow of capital to Armenia.6

Counterexample: American economic development

Although Lucas’ original hypothesis has widely been accepted as descriptive of the modern period in history, the paradox does not emerge as clearly before the 20th century. The colonial era, for instance, stands out as an age of unimpeded capital flows. The system of imperialism produced economic conditions particularly amenable to the movement of capital according to the assumptions of classical economics. Britain, for instance, was able to design, impose, and control the quality of institutions in its colonies to capitalize on the high returns to capital in the new world.7

Jeffrey Williamson has explored in depth this reversal of the Lucas Paradox in the colonial context. Although not emphasized by Lucas himself, Williamson maintains that unimpeded labor migration is one way that capital flows to the citizens of developing nations. The empire structure was particularly important for facilitating low-cost international migration, allowing wage rates to converge across the regions in the British Empire.8 For instance, in the 17th and 18th century, England incentivized its citizens to move to the labor-scarce Americas, endorsing a system of indentured servitude to make overseas migration affordable.

While Britain enabled free capital flow from old to new world, the success of the American enterprise after the American Revolution is a good example of the role of institutional and legal frameworks for facilitating a continued flow of capital. The U.S. constitution’s commitment to private property rights, rights of personal liberty; and strong contract law enabled investment from Britain to America to continue even without the incentives of the colonial relationship.9 In these ways, early American economic development, both pre and post-revolution, provides a case study for the conditions under which the Lucas Paradox is reversed. Even after the average income level in America exceeded that of Britain, the institutions exported under imperialism and the legal frameworks established after independence enabled long-term capital flows from Europe to America.

See also

References

  1. Lucas, Robert (1990). "Why doesn't Capital Flow from Rich to Poor Countries?". American Economic Review. 80 (2): 92–96. /wiki/Robert_E._Lucas,_Jr. ↩

  2. Alfaro, Laura; Kalemli-Ozcan, Sebnem; Volosovych, Vadym (2008). "Why Doesn't Capital Flow from Rich to Poor Countries? An Empirical Investigation" (PDF). Review of Economics and Statistics. 90 (2): 347–368. doi:10.1162/rest.90.2.347. S2CID 16534017. http://www.uh.edu/econpapers/RePEc/hou/wpaper/2003-01.pdf ↩

  3. Montiel, Peter. "Obstacles to Investment in Africa: Explaining the Lucas Paradox" (PDF). Article. Retrieved 27 February 2011. http://www.imf.org/external/np/seminars/eng/2006/rppia/pdf/montie.pdf ↩

  4. Daude, Christian (2007). "The Quality of Institutions and Foreign Direct Investment". Economics & Politics. 19 (3): 317–344. doi:10.1111/j.1468-0343.2007.00318.x. S2CID 27057925. /wiki/Doi_(identifier) ↩

  5. Saha, Sadhon; Sadekin, Md. Nazmus; Saha, Sanjoy Kumar (2022-10-01). "Effects of institutional quality on foreign direct investment inflow in lower-middle income countries". Heliyon. 8 (10): e10828. Bibcode:2022Heliy...810828S. doi:10.1016/j.heliyon.2022.e10828. ISSN 2405-8440. PMC 9547205. PMID 36217489. https://www.ncbi.nlm.nih.gov/pmc/articles/PMC9547205 ↩

  6. MARTIROSYAN, Arevik. "THE LUCAS PARADOX. THE REASONS BEHIND THE LOW CAPITAL FLOW INTO ARMENIA" (PDF). Article. Retrieved 6 December 2022. http://alternative.am/wp-content/uploads/2017/03/%D5%8D%D5%B5%D5%B8%D6%82%D5%A6%D5%A5%D5%BF%D5%A1-%D5%84%D4%B1%D5%90%D5%8F%D4%BB%D5%90%D5%88%D5%8D%D5%85%D4%B1%D5%86-%D4%B1%D6%80%D6%87%D5%AB%D5%AF-%D5%8D%D4%B1%D5%90%D4%B3%D5%8D%D5%85%D4%B1%D5%86-%D4%BC%D5%B8%D6%82%D5%AF%D5%A1%D5%BD%D5%AB-%D5%BA%D5%A1%D6%80%D5%A1%D5%A4%D5%B8%D6%84%D5%BD%D5%A8.-%D5%A4%D5%A5%D5%BA%D5%AB-%D5%80%D5%A1%D5%B5%D5%A1%D5%BD%D5%BF%D5%A1%D5%B6-%D5%AF%D5%A1%D5%BA%D5%AB%D5%BF%D5%A1%D5%AC%D5%AB-%D5%A9%D5%B8%D6%82%D5%B5%D5%AC-%D5%B6%D5%A5%D6%80%D5%B0%D5%B8%D5%BD%D6%84%D5%AB-%D5%BA%D5%A1%D5%BF%D5%B3%D5%A1%D5%BC%D5%B6%D5%A5%D6%80%D5%A8.pdf ↩

  7. Schularick, Moritz. "The Lucas Paradox and the Quality of Institutions: Then and Now" (PDF). Archived from the original (PDF) on 19 July 2011. Retrieved 21 February 2011. https://web.archive.org/web/20110719025638/http://www.jfki.fu-berlin.de/faculty/economics/team/persons/schularick/Lucas_discussion_paper_FUB.pdf ↩

  8. Williamson, Jeffrey (2002). "Winners and Losers Over Two Centuries of Globalization". NBER Working Paper No. 9161. Working Paper Series. doi:10.3386/w9161. https://www.nber.org/papers/w9161 ↩

  9. Ferguson, Niall. "The British Empire and Globalization". Retrieved 28 February 2011. http://www.originofnations.org/British_Empire/british_empire_and_globalization.htm ↩